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All Textbook Solutions for Financial Management: Theory & Practice
1Q2Q3Q4QDescribe the ways in which capital can be transferred from suppliers of capital to those who are demanding capital.What are financial intermediaries, and what economic functions do they perform?
7Q8QDescribe some similarities and differences among broker-dealer networks, alternative trading systems (ATS), and registered stock exchanges.What are some similarities and differences between the NYSE and the NASDAQ Stock Market?1MCAssume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firms clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre. Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.3MC4MC5MCAssume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.
What are free cash flows?
7MCAssume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firms clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre. How do free cash flows and the weighted average cost of capital interact to determine a firms value?Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.
Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?
10MCAssume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firms clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre. What are some economic conditions that affect the cost of money?
What are financial securities? Describe some financial instruments.
13MCAssume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre.
What are some different types of markets?
15MCWhat are the differences between market orders and limit orders?Briefly explain mortgage securitization and how it contributed to the global economic crisis.
Briefly explain mortgage securitization and how it contributed to the global economic crisis.
Define each of the following terms:
Annual report; balance sheet; income statement
Common stockholders’ equity, or net worth; retained earnings
Statement of stockholders’ equity; statement of cash flows
Depreciation; amortization; EBITDA
Operating current assets; operating current liabilities; net operating working capital; total net operating capital
Accounting profit; net cash flow; NOPAT; free cash flow; return on invested capital
Market Value Added; Economic Value Added
Progressive tax; taxable income; marginal and average tax rates
Capital gain or loss; tax loss carryforward
Improper accumulation; S corporation
2QIf a typical firm reports 20 million of retained earnings on its balance sheet, can the firm definitely pay a 20 million cash dividend?What is operating capital, and why is it important?6Q7Q8QAn investor recently purchased a corporate bond that yields 7.68%. The investor is in the 25% federal-plus-state tax bracket. What is the bonds after-tax yield to the investor?Corporate bonds issued by Johnson Corporation currently yield 8.0%. Municipal bonds of equal risk currently yield 5.5%. At what personal tax rate would an investor be indifferent between these two bonds?Hollys Art Galleries recently reported 7.9 million of net income. Its EBIT was 13 million, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was its interest expense? (Hint: Write out the headings for an income statement and then fill in the known values. Then divide 7.9 million net income by 1 T = 0.79 to find the pre-tax income. The difference between EBIT and taxable income must be the interest expense. Use this procedure to work some of the other problems.)Nicholas Health Systems recently reported an EBITDA of $25.0 million and net income of $15.8 million. It had $2.0 million of interest expense, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was its charge for depreciation and amortization?
Kendall Corners Inc. recently reported net income of 3.1 million and depreciation of 500,000. What was its net cash flow? Assume it had no amortization expense.In its most recent financial statements, Del-Castillo Inc. reported 70 million of net income and 900 million of retained earnings. The previous retained earnings were 855 million. How much in dividends did the firm pay to shareholders during the year?7P8P
Carter Swimming Pools has $16 million in net operating profit after taxes (NOPAT) in the current year. Carter has $12 million in total net operating assets in the current year and had $10 million in the previous year. What is its free cash flow?
10P11PThe Shrieves Corporation has 10,000 that it plans to invest in marketable securities. It is choosing among ATT bonds (which yield 6.6%), ATT preferred stock (with a dividend yield of 6.0%), and state of Florida muni bonds (which yield 5% but are not taxable). The federal tax rate is 21% (ignore any possible state corporate taxes). Recall that 50% of dividends received are tax exempt. Find the after-tax rates of return on all three securities after paying federal corporate taxes.The Moore Corporation has operating income (EBIT) of $750,000. Its depreciation expense is $200,000. Moore is 100% equity financed. The federal tax rate is 21% (ignore any possible state corporate taxes). What is the company’s net income? What is its net cash flow?
The Berndt Corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. The federal tax rate is 21% (ignore any possible state corporate taxes). Berndt has no debt.
Set up an income statement. What is Berndt’s expected net income? Its expected net cash flow?
Suppose Congress changed the tax laws so that Berndt’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?
Now suppose that Congress changed the tax laws such that, instead of doubling Berndt’s depreciation, it was reduced by 50%. How would profit and net cash flow be affected?
If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?
Use the following income statement of Elliott Game Theory Consulting to determine its net operating profit after taxes (NOPAT). Use 25% as the tax rate. Elliott Game Theory Consulting Income Statement for Year Ending December 3116PAthenian Venues Inc. just reported the following selected portion of its financial statements for the end of 2020. Your assistant has already calculated the 2020 end-of-year net operating working capital (NOWC) from the full set of financial statements (not shown here), which is 13 million. The total net operating capital for 2019 was 50 million. What was the 2020 net investment in operating capital? Athenian Venues Inc.: Selected Balance Sheet Information as of December 31 (Millions of Dollars)Rhodes Corporations financial statements are shown after part f. Suppose the federal-plus-state tax corporate tax is 25%. Answer the following questions. a. What is the net operating profit after taxes (NOPAT) for 2020? b. What are the amounts of net operating working capital for both years? c. What are the amounts of total net operating capital for both years? d. What is the free cash flow for 2020? e. What is the ROIC for 2020? f. How much of the FCF did Rhodes use for each of the following purposes: after-tax interest, net debt repayments, dividends, net stock repurchases, and net purchases of short-term investments? (Hint: Remember that a net use can be negative.) Rhodes Corporation: Income Statements for Year Ending December 31 (Millions of Dollars) Rhodes Corporation: Balance Sheets as of December 31 (Millions of Dollars)The Bookbinder Company had 500,000 cumulative operating losses prior to the beginning of last year. It had 100,000 in pre-tax earnings last year before using the past operating losses and has 300,000 in the current year before using any past operating losses. It projects 350,000 pre-tax earnings next year. a. How much taxable income was there last year? How much, if any, cumulative losses remained at the end of the last year? b. What is the taxable income in the current year? How much, if any, cumulative losses remain at the end of the current year? c. What is the projected taxable income for next year? How much, if any, cumulative losses are projected to remain at the end of next year?Begin with the partial model in the file Ch02 P20 Build a Model.xlsx on the textbook’s Web site.
Britton String Corp. manufactures specialty strings for musical instruments and tennis racquets. Its most recent sales were $880 million; operating costs (excluding depreciation) were equal to 85% of sales; net fixed assets were $300 million; depreciation amounted to 10% of net fixed assets; interest expenses were $22 million; the state-plus-federal corporate tax rate was 25%; and it paid 40% of its net income out in dividends. Given this information, construct Britton String’s income statement. Also calculate total dividends and the addition to retained earnings. Report all dollar figures in millions.
Britton String’s partial balance sheets follow. Britton issued $36 million of new common stock in the most recent year. Using this information and the results from part a, fill in the missing values for common stock, retained earnings, total common equity, and total liabilities and equity.
Construct the statement of cash flows for 2020.
Britton Strings Corp: Balance Sheets as of December 31 (Millions of Dollars)
Begin with the partial model in the file Ch02 P21 Build a Model.xlsx on the textbooks Web site. a. Using the financial statements shown here for Lan Chen Technologies, calculate net operating working capital, total net operating capital, net operating profit after taxes, free cash flow, and return on invested capital for 2020. The federal-plus-state tax rate is 25%. b. Assume there were 15 million shares outstanding at the end of 2019, the year-end closing stock price was 65 per share, and the after-tax cost of capital was 10%. Calculate EVA and MVA for 2020. Lan Chen Technologies: Income Statements for Year Ending December 31 (Millions of Dollars) Lan Chen Technologies: December 31 Balance Sheets (Thousands of Dollars)
Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components.
During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data.
Assume that you are Cochran’s assistant and that you must help her answer the following questions:
What effect did the expansion have on sales and net income? What effect did the expansion have on the asset side of the balance sheet? What effect did it have on liabilities and equity?
Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components. During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data. What do you conclude from the statement of cash flows?Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components. During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data. What is free cash flow? Why is it important? What are FCFs five uses?What is Computrons net operating profit after taxes (NOPAT)? What are operating current assets? What are operating current liabilities? How much net operating working capital and total net operating capital does Computron have?What is Computron’s free cash flow? What are Computron’s “net uses” of its FCF?
Calculate Computron’s return on invested capital (ROIC). Computron has a 10% cost of capital (WACC). What caused the decline in the ROIC? Was it due to operating profitability or capital utilization? Do you think Computron’s growth added value?
Jenny Cochran, a graduate of the University of Tennessee with 4 years of experience as an equities analyst, was recently brought in as assistant to the chairman of the board of Computron Industries, a manufacturer of computer components. During the previous year, Computron had doubled its plant capacity, opened new sales offices outside its home territory, and launched an expensive advertising campaign. Cochran was assigned to evaluate the impact of the changes. She began by gathering financial statements and other data. Cochran also has asked you to estimate Computrons Economic Value Added (EVA). She estimates that the after-tax cost of capital was 10% in both years.What happened to Computron’s Market Value Added (MVA)?
9MC10MC11MC12MCDefine each of the following terms:
Liquidity ratios: current ratio; quick, or acid test, ratio
Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed assets turnover ratio; total assets turnover ratio
Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; EBITDA coverage ratio
Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on total assets (ROA); return on common equity (ROE)
Market value ratios: price/earnings (P/E) ratio; price/free cash flow ratio; market/book (M/B) ratio; book value per share
Trend analysis; comparative ratio analysis; benchmarking
DuPont equation; window dressing; seasonal effects on ratios
Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?Over the past year, M. D. Ryngaert Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the companys sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between a grocery chain and a steel company? Think particularly about the turnover ratios, the profit margin, and the DuPont equation.
How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. How might these problems be alleviated?Why is it sometimes misleading to compare a companys financial ratios with those of other firms that operate in the same industry?Greene Sisters has a DSO of 20 days. The company’s average daily sales are $20,000. What is the level of its accounts receivable? Assume there are 365 days in a year.
Vigo Vacations has $200 million in total assets, $5 million in notes payable, and $25 million in long-term debt. What is the debt ratio?
Winston Watchs stock price is 75 per share. Winston has 10 billion in total assets. Its balance sheet shows 1 billion in current liabilities, 3 billion in long-term debt, and 6 billion in common equity. It has 800 million shares of common stock outstanding. What is Winstons market/book ratio?Reno Revolvers has an EPS of $1.50, a free cash flow per share of $3.00, and a price/free cash flow ratio of 8.0. What is its P/E ratio?
Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of 2.0. Its sales are 100 million, and it has total assets of 50 million. What is its ROE?Gardial Son has an ROA of 12%, a 5% profit margin, and a return on equity equal to 20%. What is the companys total assets turnover? What is the firms equity multiplier?Ace Industries has current assets equal to 3 million. The companys current ratio is 1.5, and its quick ratio is 1.0. What is the firms level of current liabilities? What is the firms level of inventories?Assume you are given the following relationships for the Haslam Corporation:
Calculate Haslam’s profit margin and liabilities-to-assets ratio. Suppose half its liabilities are in the form of debt. Calculate the debt-to-assets ratio.
9PThe Morrit Corporation has $600,000 of debt outstanding, and it pays an interest rate of 8% annually. Morrit’s annual sales are $3 million, its average tax rate is 25%, and its net profit margin on sales is 3%. If the company does not maintain a TIE ratio of at least 5 to 1, then its bank will refuse to renew the loan, and bankruptcy will result. What is Morrit’s TIE ratio?
Complete the balance sheet and sales information in the table that follows for J. White Industries, using the following financial data: Total assets turnover: 1.5 Gross profit margin on sales: (Sales Cost of goods sold)/Sales = 25% Total liabilities-to-assets ratio: 40% Quick ratio: 0.80 Days sales outstanding (based on 365-day year): 36.5 days Inventory turnover ratio: 3.75 Partial Income Statement Information Balance Sheet InformationThe Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, a days sales outstanding of 36.5 days (based on a 365-day year), total current assets of 810,000, and cash and marketable securities of 120,000. What were Kretovichs annual sales?Data for Lozano Chip Company and its industry averages follow.
Calculate the indicated ratios for Lozano.
Construct the extended DuPont equation for both Lozano and the industry.
Outline Lozano’s strengths and weaknesses as revealed by your analysis.
Lozano Chip Company: Balance Sheet as of December 31, 2019 (Thousands of Dollars)
Lozano Chip Company: Income Statement for Year Ended December 31, 2019 (Thousands of Dollars)
The Jimenez Corporation’s forecasted 2020 financial statements follow, along with some industry average ratios. Calculate Jimenez’s 2020 forecasted ratios, compare them with the industry average data, and comment briefly on Jimenez’s projected strengths and weaknesses.
Jimenez Corporation: Forecasted Balance Sheet as of December 31, 2020
Jimenez Corporation: Forecasted Income Statement for 2020
Jimenez Corporation: Per Share Data for 2020
Notes:
aIndustry average ratios have been stable for the past 4 years.
bBased on year-end balance sheet figures.
cCalculation is based on a 365-day year.
Why are ratios useful? What three groups use ratio analysis and for what reasons?Calculate the projected profit margin, operating profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?
Calculate the projected inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Computron’s utilization of assets stack up against that of other firms in its industry?
4MCCalculate the projected debt ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest-earned ratio, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?
Calculate the projected price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?7MCUse the extended DuPont equation to provide a breakdown of Computrons projected return on equity. How does the projection compare with the previous years and with the industrys DuPont equation?What are some potential problems and limitations of financial ratio analysis?
What are some qualitative factors that analysts should consider when evaluating a companys likely future financial performance?2QAn annuity is defined as a series of payments of a fixed amount for a specific number of periods. Thus, $100 a year for 10 years is an annuity, but $100 in Year 1, $200 in Year 2, and $400 in Years 3 through 10 does not constitute an annuity. However, the entire series does contain an annuity. Is this statement true or false?
If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain.
5QIf you deposit 10,000 in a bank account that pays 10% interest annually, how much will be in your account after 5 years?What is the present value of a security that will pay $5,000 in 20 years if securities of equal risk pay 7% annually?
Your parents will retire in 18 years. They currently have 250,000, and they think they will need 1 million at retirement. What annual interest rate must they earn to reach their goal, assuming they dont save any additional funds?4PYou have $42,180.53 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals $250,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal?
What is the future value of a 7%, 5-year ordinary annuity that pays 300 each year? If this were an annuity due, what would its future value be?An investment will pay 100 at the end of each of the next 3 years, 200 at the end of Year 4, 300 at the end of Year 5, and 500 at the end of Year 6. If other investments of equal risk earn 8% annually, what is this investments present value? Its future value?You want to buy a car, and a local bank will lend you $20,000. The loan would be fully amortized over 5 years (60 months), and the nominal interest rate would be 12%, with interest paid monthly. What is the monthly loan payment? What is the loan’s EFF%?
Find the following values, using the equations, and then work the problems using a financial calculator to check your answers. Disregard rounding differences. (Hint: If you are using a financial calculator, you can enter the known values and then press the appropriate key to find the unknown variable. Then, without clearing the TVM register, you can override the variable that changes by simply entering a new value for it and then pressing the key for the unknown variable to obtain the second answer. This procedure can be used in parts b and d, and in many other situations, to see how changes in input variables affect the output variable.) a. An initial 500 compounded for 1 year at 6% b. An initial 500 compounded for 2 years at 6% c. The present value of 500 due in 1 year at a discount rate of 6% d. The present value of 500 due in 2 years at a discount rate of 6%Use both the TVM equations and a financial calculator to find the following values. See the Hint for Problem 4-9. a. An initial 500 compounded for 10 years at 6% b. An initial 500 compounded for 10 years at 12% c. The present value of 500 due in 10 years at a 6% discount rate d. The present value of 500 due in 10 years at a 12% discount rateFind the future value of the following annuities. The first payment in these annuities is made at the end of Year 1, so they are ordinary annuities. (Notes: See the Hint to Problem 4-9. Also, note that you can leave values in the TVM register, switch to Begin Mode, press FV, and find the FV of the annuity due.) a. 400 per year for 10 years at 10% b. 200 per year for 5 years at 5% c. 400 per year for 5 years at 0% d. Now rework parts a, b, and c assuming that payments are made at the beginning of each year; that is, they are annuities due.13P14PFind the interest rate (or rates of return) in each of the following situations. a. You borrow 700 and promise to pay back 749 at the end of 1 year. b. You lend 700 and receive a promise to be paid 749 at the end of 1 year. c. You borrow 85,000 and promise to pay back 201,229 at the end of 10 years. d. You borrow 9,000 and promise to make payments of 2,684.80 at the end of each of the next 5 years.16PFind the present value of 500 due in the future under each of the following conditions. a. 12% nominal rate, semiannual compounding, discounted back 5 years b. 12% nominal rate, quarterly compounding, discounted back 5 years c. 12% nominal rate, monthly compounding, discounted back 1 year18PUniversal Bank pays 7% interest, compounded annually, on time deposits. Regional Bank pays 6% interest, compounded quarterly.
Based on effective interest rates, in which bank would you prefer to deposit your money?
Could your choice of banks be influenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? In answering this question, assume that funds must be left on deposit during an entire compounding period in order for you to receive any interest.
Sales for Hanebury Corporation’s just-ended year were $12 million. Sales were $6 million 5 years earlier.
At what rate did sales grow?
Suppose someone calculated the sales growth for Hanebury in part a as follows: “Sales doubled in 5 years. This represents a growth of 100% in 5 years; dividing 100% by 5 results in an estimated growth rate of 20% per year.” Explain what is wrong with this calculation.
Washington-Pacific (W-P) invested $4 million to buy a tract of land and plant some young pine trees. The trees can be harvested in 10 years, at which time W-P plans to sell the forest at an expected price of $8 million. What is W-P’s expected rate of return?
A mortgage company offers to lend you 85,000; the loan calls for payments of 8,273.59 at the end of each year for 30 years. What interest rate is the mortgage company charging you?To complete your last year in business school and then go through law school, you will need $10,000 per year for 4 years, starting next year (that is, you will need to withdraw the first $10,000 one year from today). Your uncle offers to put you through school, and he will deposit in a bank paying 7% interest a sum of money that is sufficient to provide the four payments of $10,000 each. His deposit will be made today.
How large must the deposit be?
How much will be in the account immediately after you make the first withdrawal? After the last withdrawal?
25PYou need to accumulate 10,000. To do so, you plan to make deposits of 1,250 per yearwith the first payment being made a year from todayinto a bank account that pays 12% annual interest. Your last deposit will be less than 1,250 if less is needed to round out to 10,000. How many years will it take you to reach your 10,000 goal, and how large will the last deposit be?27PAssume that you inherited some money. A friend of yours is working as an unpaid intern at a local brokerage firm, and her boss is selling securities that call for 4 payments of 50 (1 payment at the end of each of the next 4 years) plus an extra payment of 1,000 at the end of Year 4. Your friend says she can get you some of these securities at a cost of 900 each. Your money is now invested in a bank that pays an 8% nominal (quoted) interest rate but with quarterly compounding. You regard the securities as being just as safe, and as liquid, as your bank deposit, so your required effective annual rate of return on the securities is the same as that on your bank deposit. You must calculate the value of the securities to decide whether they are a good investment. What is their present value to you?Assume that your aunt sold her house on December 31, and to help close the sale she took a second mortgage in the amount of 10,000 as part of the payment. The mortgage has a quoted (or nominal) interest rate of 10%; it calls for payments every 6 months, beginning on June 30, and is to be amortized over 10 years. Now, 1 year later, your aunt must inform the IRS and the person who bought the house about the interest that was included in the two payments made during the year. (This interest will be income to your aunt and a deduction to the buyer of the house.) To the closest dollar, what is the total amount of interest that was paid during the first year?Your company is planning to borrow $1 million on a 5-year, 15%, annual payment, fully amortized term loan. What fraction of the payment made at the end of the second year will represent repayment of principal?
31P32PYou want to accumulate $1 million by your retirement date, which is 25 years from now. You will make 25 deposits in your bank, with the first occurring today. The bank pays 8% interest, compounded annually. You expect to receive annual raises of 3%, which will offset inflation, and you will let the amount you deposit each year also grow by 3% (i.e., your second deposit will be 3% greater than your first, the third will be 3% greater than the second, etc.). How much must your first deposit be if you are to meet your goal?
1MC2MCWe sometimes need to find out how long it will take a sum of money (or something else, such as earnings, population, or prices) to grow to some specified amount. For example, if a company’s sales are growing at a rate of 20% per year, how long will it take sales to double?
If you want an investment to double in 3 years, what interest rate must it earn?Whats the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How would you change the time line to show the other type of annuity?6MC7MCDefine the stated (quoted) or nominal rate INOM as well as the periodic rate IPER.
Will the future value be larger or smaller if we compound an initial amount more often than annually—for example, every 6 months, or semiannually—holding the stated interest rate constant? Why?
What is the future value of $100 after 5 years under 12% annual compounding? Semiannual compounding? Quarterly compounding? Monthly compounding? Daily compounding?
What is the effective annual rate (EAR or EFF%)? What is the EFF% for a nominal rate of 12%, compounded semiannually? Compounded quarterly? Compounded monthly? Compounded daily?
Will the effective annual rate ever be equal to the nominal (quoted) rate?
(1) Construct an amortization schedule for a 1,000, 10% annual rate loan with three equal installments. (2) During Year 2, what is the annual interest expense for the borrower, and what is the annual interest income for the lender?11MC(1) What is the value at the end of Year 3 of the following cash flow stream if the quoted interest rate is 10%, compounded semiannually? (2) What is the PV of the same stream? (3) Is the stream an annuity? (4) An important rule is that you should never show a nominal rate on a time line or use it in calculations unless what condition holds? (Hint: Think of annual compounding, when INOM = EFF% = IPER.) What would be wrong with your answers to parts (1) and (2) if you used the nominal rate of 10% rather than the periodic rate, INOM/2 = 10%/2 = 5%?Suppose someone offered to sell you a note calling for the payment of 1,000 in 15 months. They offer to sell it to you for 850. You have 850 in a bank time deposit that pays a 6.76649% nominal rate with daily compounding, which is a 7% effective annual interest rate, and you plan to leave the money in the bank unless you buy the note. The note is not riskyyou are sure it will be paid on schedule. Should you buy the note? Check the decision in three ways: (1) by comparing your future value if you buy the note versus leaving your money in the bank; (2) by comparing the PV of the note with your current bank account; and (3) by comparing the EFF% on the note with that of the bank account.Short-term interest rates are more volatile than long-term interest rates, so short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Is this statement true or false? Explain.The rate of return on a bond held to its maturity date is called the bonds yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bonds price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bonds price? Why or why not?If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.A sinking fund can be set up in one of two ways. Discuss the advantages and disadvantages of each procedure from the viewpoint of both the firm and its bondholders.
1PWilson Corporations bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a 1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of 850. What is their yield to maturity?3PThe real risk-free rate of interest is 4%. Inflation is expected to be 2% this year and 4% during each of the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2-year Treasury security yields 6.3%. What is the maturity risk premium for the 2-year security?
Renfro Rentals has issued bonds that have a 10% coupon rate, payable semiannually. The bonds mature in 8 years, have a face value of 1,000, and a yield to maturity of 8.5%. What is the price of the bonds?Thatcher Corporations bonds will mature in 10 years. The bonds have a face value of 1,000 and an 8% coupon rate, paid semiannually. The price of the bonds is 1,100. The bonds are callable in 5 years at a call price of 1,050. What is their yield to maturity? What is their yield to call?The Garraty Company has two bond issues outstanding. Both bonds pay 100 annual interest plus 1,000 at maturity. Bond L has a maturity of 15 years, and Bond S has a maturity of 1 year. a. What will be the value of each of these bonds when the going rate of interest is (1) 5%, (2) 8%, and (3) 12%? Assume that there is only one more interest payment to be made on Bond S. b. Why does the longer-term (15-year) bond fluctuate more when interest rates change than does the shorter-term bond (1 year)?10PGoodwynn & Wolf Incorporated (G&W) issued a bond 7 years ago. The bond had a 20-year maturity, a 14% coupon paid annually, a 9% call premium and was issued at par, $1,000. Today, G&W called the bonds. If the original investors had expected G&W to call the bonds in 7 years, what was the yield to call at the time the bonds were issued?
12PYou just purchased a bond that matures in 5 years. The bond has a face value of 1,000 and an 8% annual coupon. The bond has a current yield of 8.21%. What is the bonds yield to maturity?A bond that matures in 7 years sells for 1,020. The bond has a face value of 1,000 and a yield to maturity of 10.5883%. The bond pays coupons semiannually. What is the bonds current yield?15PA bond trader purchased each of the following bonds at a yield to maturity of 8%. Immediately after she purchased the bonds, interest rates fell to 7%. What is the percentage change in the price of each bond after the decline in interest rates? Fill in the following table:An investor has two bonds in his portfolio. Each bond matures in 4 years, has a face value of 1,000, and has a yield to maturity equal to 9.6%. One bond, Bond C, pays an annual coupon of 10%; the other bond, Bond Z, is a zero coupon bond. Assuming that the yield to maturity of each bond remains at 9.6% over the next 4 years, what will be the price of each of the bonds at the following time periods? Fill in the following table:The real risk-free rate is 2%. Inflation is expected to be 3% this year, 4% next year, and then 3.5% thereafter. The maturity risk premium is estimated to be 0.0005 × (t − 1), where t = number of years to maturity. What is the nominal interest rate on a 7-year Treasury security?
19P20PSuppose Hillard Manufacturing sold an issue of bonds with a 10-year maturity, a $1,000 par value, a 10% coupon rate, and semiannual interest payments.
Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6%. At what price would the bonds sell?
Suppose that 2 years after the initial offering, the going interest rate had risen to 12%. At what price would the bonds sell?
Suppose that 2 years after the issue date (as in Part a) interest rates fell to 6%. Suppose further that the interest rate remained at 6% for the next 8 years. What would happen to the price of the bonds over time?
Arnot International’s bonds have a current market price of $1,200. The bonds have an 11% annual coupon payment, a $1,000 face value, and 10 years left until maturity. The bonds may be called in 5 years at 109% of face value (call price = $1,090).
What is the yield to maturity?
What is the yield to call if they are called in 5 years?
Which yield might investors expect to earn on these bonds, and why?
The bond’s indenture indicates that the call provision gives the firm the right to call them at the end of each year beginning in Year 5. In Year 5, they may be called at 109% of face value, but in each of the next 4 years the call percentage will decline by 1 percentage point. Thus, in Year 6 they may be called at 108% of face value, in Year 7 they may be called at 107% of face value, and so on. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?
23P24SP1MC2MC3MCHow is the value of a bond determined? What is the value of a 10-year, 1,000 par value bond with a 10% annual coupon if its required rate of return is 10%?What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13% return? Would we now have a discount or a premium bond?
What would happen to the bond’s value if inflation fell and rd declined to 7%? Would we now have a premium or a discount bond?
What would happen to the value of the 10-year bond over time if the required rate of return remained at 13%? If it remained at 7%? (Hint: With a financial calculator, enter PMT, I/YR, FV, and N, and then change N to see what happens to the PV as the bond approaches maturity.)
Suppose a 10-year, 10% semiannual coupon bond with a par value of 1,000 is currently selling for 1,135.90, producing a nominal yield to maturity of 8%. However, the bond can be called after 5 years for a price of 1,050. (1) What is the bonds nominal yield to call (YTC)? (2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?Write a general expression for the yield on any debt security (rd) and define these terms: real risk-free rate of interest (r), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).Define the real risk-free rate (r). What security can be used as an estimate of r? What is the nominal risk-free rate (rRF)? What securities can be used as estimates of rRF?11MC12MC14MCHow are interest rate risk and reinvestment rate risk related to the maturity risk premium?What is the term structure of interest rates? What is a yield curve?Briefly describe bankruptcy law. If a firm were to default on its bonds, would the company be liquidated immediately? Would the bondholders be assured of receiving all of their promised payments?
The probability distribution of a less risky return is more peaked than that of a riskier return. What shape would the probability distribution have for (a) completely certain returns and (b) completely uncertain returns?
Security A has an expected return of 7%, a standard deviation of returns of 35%, a correlation coefficient with the market of 0.3, and a beta coefficient of 1.5. Security B has an expected return of 12%, a standard deviation of returns of 10%, a correlation with the market of 0.7, and a beta coefficient of 1.0. Which security is riskier? Why?If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.
5QYour investment club has only two stocks in its portfolio. 20,000 is invested in a stock with a beta of 0.7, and 35,000 is invested in a stock with a beta of 1.3. What is the portfolios beta?2PSuppose that the risk-free rate is 5% and that the market risk premium is 7%. What is the required return on (1) the market, (2) a stock with a beta of 1.0, and (3) a stock with a beta of 1.7?
An analyst gathered daily stock returns for Feburary 1 through March 31, calculated the Fama-French factors for each day in the sample (SMBt and HMLt), and estimated the Fama-French regression model shown in Equation 6-21. The estimated coefficients were ai = 0, bi = 1.2, ci = 0.4, and di = 1.3. On April 1, the market return was 10%, the return on the SMB portfolio (rSMB) was 3.2%, and the return on the HML portfolio (rHML) was 4.8%. Using the estimated model, what was the stocks predicted return for April 1?A stocks return has the following distribution: Calculate the stocks expected return and standard deviation.The market and Stock J have the following probability distributions: a. Calculate the expected rates of return for the market and Stock J. b. Calculate the standard deviations for the market and Stock J.Suppose rRF = 5%, rM = 10%, and rA = 12%. a. Calculate Stock As beta. b. If Stock As beta were 2.0, then what would be As new required rate of return?As an equity analyst you are concerned with what will happen to the required return for Universal Toddlers stock as market conditions change. Suppose rRF = 5%, rM = 12%, and bUT = 1.4. a. Under current conditions, what is rUT, the required rate of return on UT stock? b. Now suppose rRF (1) increases to 6% or (2) decreases to 4%. The market risk premium, RPM, (i.e., the slope of the SML) remains constant. How would this affect rM and rUT? c. Now assume rRF remains at 5% but rM (1) increases to 14% or (2) falls to 11%. The market risk premium, RPM, (i.e., the slope of the SML) does not remain constant. How would these changes affect rUT?Your retirement fund consists of a $5,000 investment in each of 15 different common stocks. The portfolio’s beta is 1.20. Suppose you sell one of the stocks with a beta of 0.8 for $5,000 and use the proceeds to buy another stock whose beta is 1.6. Calculate your portfolio’s new beta.
10PYou have a $2 million portfolio consisting of a $100,000 investment in each of 20 different stocks. The portfolio has a beta of 1.1. You are considering selling $100,000 worth of one stock with a beta of 0.9 and using the proceeds to purchase another stock with a beta of 1.4. What will the portfolio’s new beta be after these transactions?
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is 13%, and the risk-free rate is 7%. By how much does the required return on the riskier stock exceed that on the less risky stock?You are considering an investment in either individual stocks or a portfolio of stocks. The two stocks you are researching, Stock A and Stock B, have the following historical returns: a. Calculate the average rate of return for each stock during the 5-year period. b. Suppose you had held a portfolio consisting of 50% of Stock A and 50% of Stock B. What would have been the realized rate of return on the portfolio in each year? What would have been the average return on the portfolio during this period? c. Calculate the standard deviation of returns for each stock and for the portfolio. d. Suppose you are a risk-averse investor. Assuming Stocks A and B are your only choices, would you prefer to hold Stock A, Stock B, or the portfolio? Why?You have observed the following returns over time:
Assume that the risk-free rate is 6% and the market risk premium is 5%.
What are the betas of Stocks X and Y?
What are the required rates of return on Stocks X and Y?
What is the required rate of return on a portfolio consisting of 80% of Stock X and 20% of Stock Y?
What are investment returns? What is the return on an investment that costs $1,000 and is sold after 1 year for $1,060?
Graph the probability distribution for the bond returns based on the 5 scenarios. What might the graph of the probability distribution look like if there were an infinite number of scenarios (i.e., if it were a continuous distribution and not a discrete distribution)?Use the scenario data to calculate the expected rate of return for the 10-year zero coupon Treasury bonds during the next year.What is the stand-alone risk? Use the scenario data to calculate the standard deviation of the bonds return for the next year.Your client has decided that the risk of the bond portfolio is acceptable and wishes to leave it as it is. Now your client has asked you to use historical returns to estimate the standard deviation of Blandy’s stock returns. (Note: Many analysts use 4 to 5 years of monthly returns to estimate risk, and many use 52 weeks of weekly returns; some even use a year or less of daily returns. For the sake of simplicity, use Blandy’s 10 annual returns.)
Your client is shocked at how much risk Blandy stock has and would like to reduce the level of risk. You suggest that the client sell 25% of the Blandy stock and create a portfolio with 75% Blandy stock and 25% in the high-risk Gourmange stock. How do you suppose the client will react to replacing some of the Blandy stock with high-risk stock? Show the client what the proposed portfolio return would have been in each year of the sample. Then calculate the average return and standard deviation using the portfolios annual returns. How does the risk of this two-stock portfolio compare with the risk of the individual stocks if they were held in isolation?Explain correlation to your client. Calculate the estimated correlation between Blandy and Gourmange. Does this explain why the portfolio standard deviation was less than Blandys standard deviation?8MC9MC10MC11MCCalculate the correlation coefficient between Blandy and the market. Use this and the previously calculated (or given) standard deviations of Blandy and the market to estimate Blandy’s beta. Does Blandy contribute more or less risk to a well-diversified portfolio than does the average stock? Use the SML to estimate Blandy’s required return.
13MC(1) Suppose the risk-free rate goes up to 7%. What effect would higher interest rates have on the SML and on the returns required on high-risk and low-risk securities? (2) Suppose instead that investors’ risk aversion increased enough to cause the market risk premium to increase to 8%. (Assume the risk-free rate remains constant.) What effect would this have on the SML and on returns of high- and low-risk securities?
Your client decides to invest $1.4 million in Blandy stock and $0.6 million in Gourmange stock. What are the weights for this portfolio? What is the portfolio’s beta? What is the required return for this portfolio?
Jordan Jones (JJ) and Casey Carter (CC) are portfolio managers at your firm. Each manages a well-diversified portfolio. Your boss has asked for your opinion regarding their performance in the past year. JJs portfolio has a beta of 0.6 and had a return of 8.5%; CCs portfolio has a beta of 1.4 and had a return of 9.5%. Which manager had better performance? Why?What does market equilibrium mean? If equilibrium does not exist, how will it be established?
What is the Efficient Markets Hypothesis (EMH), and what are its three forms? What evidence supports the EMH? What evidence casts doubt on the EMH?Two investors are evaluating General Electric’s stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for 2 years and the other normally holds stocks for 10 years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Electric’s stock. True or false? Explain.
A bond that pays interest forever and has no maturity date is a perpetual bond, also called a perpetuity or a consol. In what respect is a perpetual bond similar to (1) a no-growth common stock and (2) a share of preferred stock?
Explain how to use the free cash flow valuation model to find the price per share of common equity.Ogier Incorporated currently has $800 million in sales, which are projected to grow by 10% in Year 1 and by 5% in Year 2. Its operating profitability ratio (OP) is 10%, and its capital requirement ratio (CR) is 80%?
What are the projected sales in Years 1 and 2?
What are the projected amounts of net operating profit after taxes (NOPAT) for Years 1 and 2?
What are the projected amounts of total net operating capital (OpCap) for Years 1 and 2?
What is the projected FCF for Year 2?
EMC Corporations current free cash flow is 400,000 and is expected to grow at a constant rate of 5%. The weighted average cost of capital is WACC = 12%. Calculate EMCs estimated value of operations.3PJenBritt Incorporated had a free cash flow (FCF) of 80 million in 2019. The firm projects FCF of 200 million in 2020 and 500 million in 2021. FCF is expected to grow at a constant rate of 4% in 2022 and thereafter. The weighted average cost of capital is 9%. What is the current (i.e., beginning of 2020) value of operations?Blunderbluss Manufacturing’s balance sheets report $200 million in total debt, $70 million in short-term investments, and $50 million in preferred stock. Blunderbluss has 10 million shares of common stock outstanding. A financial analyst estimated that Blunderbuss’s value of operations is $800 million. What is the analyst’s estimate of the intrinsic stock price per share?
Thress Industries just paid a dividend of $1.50 a share (i.e., D0 = $1.50). The dividend is expected to grow 5% a year for the next 3 years and then 10% a year thereafter. What is the expected dividend per share for each of the next 5 years?
Boehm Incorporated is expected to pay a 1.50 per share dividend at the end of this year (i.e., D1 = 1.50). The dividend is expected to grow at a constant rate of 6% a year. The required rate of return on the stock, rs, is 13%. What is the estimated value per share of Boehms stock?Woidtke Manufacturing’s stock currently sells for $22 a share. The stock just paid a dividend of $1.20 a share (i.e., D0 = $1.20), and the dividend is expected to grow forever at a constant rate of 10% a year. What stock price is expected 1 year from now? What is the estimated required rate of return on Woidtke’s stock? (Assume the market is in equilibrium with the required return equal to the expected return.)
A company currently pays a dividend of $2 per share (D0 = $2). It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years and then at a constant rate of 7% thereafter. The company’s stock has a beta of 1.2, the risk-free rate is 7.5%, and the market risk premium is 4%. What is your estimate of the stock’s current price?
Nick’s Enchiladas has preferred stock outstanding that pays a dividend of $5 at the end of each year. The preferred stock sells for $50 a share. What is the stock’s required rate of return? (Assume the market is in equilibrium with the required return equal to the expected return.)
Brook Corporation’s free cash flow for the current year (FCF0) was $3.00 million. Its investors require a 13% rate of return on (WACC = 13%). What is the estimated value of operations if investors expect FCF to grow at a constant annual rate of (1) −5%, (2) 0%, (3) 5%, or (4) 10%?
Kendra Enterprises has never paid a dividend. Free cash flow is projected to be 80,000 and 100,000 for the next 2 years, respectively; after the second year, FCF is expected to grow at a constant rate of 8%. The companys weighted average cost of capital is 12%. a. What is the terminal, or horizon, value of operations? (Hint: Find the value of all free cash flows beyond Year 2 discounted back to Year 2.) b. Calculate Kendras value of operations.Dozier Corporation is a fast-growing supplier of office products. Analysts project the following free cash flows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 7% rate. Dozier’s weighted average cost of capital is WACC = 13%.
What is Dozier’s horizon value? (Hint: Find the value of all free cash flows beyond Year 3 discounted back to Year 3.)
What is the current value of operations for Dozier?
Suppose Dozier has $10 million in marketable securities, $100 million in debt, and 10 million shares of stock. What is the intrinsic price per share?
Brushy Mountain Mining Companys coal reserves are being depleted, so its sales are falling. Also, environmental costs increase each year, so its costs are rising. As a result, the companys free cash flows are declining at the constant rate of 4% per year. If its current free cash flow (FCF0) is 6 million and its weighted average cost of capital (WACC) is 14%, what is the estimated value of Brushy Mountains value of operations?15PCrisp Cookware’s common stock is expected to pay a dividend of $3 a share at the end of this year (D1 = $3.00); its beta is 0.8. The risk-free rate is 5.2%, and the market risk premium is 6%. The dividend is expected to grow at some constant rate g, and the stock currently sells for $40 a share. Assuming the market is in equilibrium, what does the market believe will be the stock’s price at the end of 3 years (i.e., what is )?
17PAssume that the average firm in C&J Corporation’s industry is expected to grow at a constant rate of 6% and that its dividend yield is 7%. C&J is about as risky as the average firm in the industry and just paid a dividend (D0) of $1. Analysts expect that the growth rate of dividends will be 50% during the first year (g0,1 = 50%) and 25% during the second year (g1,2 = 25%). After Year 2, dividend growth will be constant at 6%. What is the required rate of return on C&J’s stock? What is the estimated intrinsic per share?
Simpkins Corporation does not pay any dividends because it is expanding rapidly and needs to retain all of its earnings. However, investors expect Simpkins to begin paying dividends, with the first dividend of 0.50 coming 3 years from today. The dividend should grow rapidlyat a rate of 80% per yearduring Years 4 and 5. After Year 5, the company should grow at a constant rate of 7% per year. If the required return on the stock is 16%, what is the value of the stock today? (Assume the market is in equilibrium with the required return equal to the expected return.)Several years ago, Rolen Riders issued preferred stock with a stated annual dividend of 10% of its 100 par value. Preferred stock of this type currently yields 8%. Assume dividends are paid annually. a. What is the estimated value of Rolens preferred stock? b. Suppose interest rate levels have risen to the point where the preferred stock now yields 12%. What would be the new estimated value of Rolens preferred stock?You buy a share of The Ludwig Corporation stock for 21.40. You expect it to pay dividends of 1.07, 1.1449, and 1.2250 in Years 1, 2, and 3, respectively, and you expect to sell it at a price of 26.22 at the end of 3 years. a. Calculate the growth rate in dividends. b. Calculate the expected dividend yield. c. Assuming that the calculated growth rate is expected to continue, you can add the dividend yield to the expected growth rate to obtain the expected total rate of return. What is this stocks expected total rate of return? (Assume the market is in equilibrium with the required return equal to the expected return.)You are analyzing Jillians Jewelry (JJ) stock for a possible purchase. JJ just paid a dividend of 1.50 yesterday. You expect the dividend to grow at the rate of 6% per year for the next 3 years; if you buy the stock, you plan to hold it for 3 years and then sell it. a. What dividends do you expect for JJ stock over the next 3 years? In other words, calculate D1, D2, and D3. Note that D0 = 1.50. b. JJ stock has a required return of 13%, the rate youll use to discount dividends. Find the present value of the dividend stream; that is, calculate the PV of D1, D2, and D3, and then sum these PVs. c. JJ stock should trade for 27.05 3 years from now (i.e., you expect P3=27.05). Discounted at a 13% rate, what is the present value of this expected future stock price? In other words, calculate the PV of 27.05. d. If you plan to buy the stock, hold it for 3 years, and then sell it for 27.05, what is the most you should pay for it? e. Use the constant growth model to calculate the present value of this stock. Assume that gL = 6% and is constant. f. Is the value of this stock dependent on how long you plan to hold it? In other words, if your planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of the stock today, P0? Explain your answer.Reizenstein Technologies (RT) has just developed a solar panel capable of generating 200% more electricity than any solar panel currently on the market. As a result, RT is expected to experience a 15% annual growth rate for the next 5 years. By the end of 5 years, other firms will have developed comparable technology, and RTs growth rate will slow to 5% per year indefinitely. RT has a 12% weighted average cost of capital. The most recent annual free cash flow (FCF0) was 1.75 million. a. Calculate RTs expected FCFs for t = 1, t = 2, t = 3, t = 4, and t = 5. b. What is the horizon value at t = 5 (HV5)? c. What is the present value of the horizon value? d. What is the present value of the free cash flows expected at t = 1, t = 2, t = 3, t = 4, and t = 5? e. What is the value of operations at t = 0?Conroy Consulting Corporation (CCC) has a current dividend of D0 = $2.5. Shareholders require a 12% rate of return. Although the dividend has been growing at a rate of 30% per year in recent years, this growth rate is expected to last only for another 2 years (g0,1 = g1,2 = 30%). After Year 2, the growth rate will stabilize at gL = 7%.
What is CCC’s stock worth today?
What is the expected stock price at Year 1?
What is the Year 1 expected (1) dividend yield, (2) capital gains yield, and (3) total return?
What is its expected dividend yield for the second year? The expected capital gains yield? The expected total return?
Start with the partial model in the file Ch07 P25 Build a Model.xlsx on the textbook’s Web site. Selected data for the Derby Corporation are shown here. Use the data to answer the following questions.
Calculate the estimated horizon value (i.e., the value of operations at the end of the forecast period immediately after the Year-4 free cash flow). Assume growth becomes constant after Year 3.
Calculate the present value of the horizon value, the present value of the free cash flows, and the estimated Year-0 value of operations.
Calculate the estimated Year-0 price per share of common equity.
26SPStart with the partial model in the file Ch07 P27 Build a Model.xlsx on the textbook’s Web site. Hamilton Landscaping’s dividend growth rate is expected to be 30% in the next year, drop to 15% from Year 1 to Year 2, and drop to a constant 5% for Year 2 and all subsequent years. Hamilton has just paid a dividend of $2.50, and its stock has a required return of 11%.
What is Hamilton’s estimated stock price today?
If you bought the stock at Year 0, what are your expected dividend yield and capital gains for the upcoming year?
What are your expected dividend yield and capital gains for the second year (from Year 1 to Year 2)? Why aren’t these the same as for the first year?
Describe briefly the legal rights and privileges of common stockholders.2MCUse a pie chart to illustrate the sources that comprise a hypothetical companys total value. Using another pie chart, show the claims on a companys value. How is equity a residual claim?Suppose the free cash flow at Time 1 is expected to grow at a constant rate of gL forever. If gL < WACC, what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of gL forever (and gL < WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?
Use BMs data and the free cash flow valuation model to answer the following questions: (1) What is its estimated value of operations? (2) What is its estimated total corporate value? (This is the entity value.) (3) What is its estimated intrinsic value of equity? (4) What is its estimated intrinsic stock price per share?You have just learned that B&M has undertaken a major expansion that will change its expected free cash flows to −$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock was added; the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and that there are still 10 million shares of stock outstanding.
What is the company’s horizon value (i.e., its value of operations at Year 3)? What is its current value of operations (i.e., at Time 0)?
What is its estimated intrinsic value of equity on a price-per-share basis?
7MC8MC9MCWhat is the horizon value at Year 4? What is the total net operating capital at Year 4? Which is larger, and what can explain the difference? What is the value of operations at Year 0? How does the Year-0 value of operations compare with the Year-0 total net operating capital?
11MC14MC15MCAssume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was 2.00 and whose dividend is expected to grow indefinitely at a 6% rate. (1) What is the firms current estimated intrinsic stock price? (2) What is the stocks expected value 1 year from now? (3) What are the expected dividend yield, the expected capital gains yield, and the expected total return during the first year?17MC18MC19MC20MC21MCDefine each of the following terms:
Option; call option; put option
Exercise value; strike price
Black-Scholes option pricing model
Why do options sell at prices higher than their exercise values?
Describe the effect on a call option’s price that results from an increase in each of the following factors: (1) stock price, (2) strike price, (3) time to expiration, (4) risk-free rate, and (5) standard deviation of stock return.
A call option on the stock of Bedrock Boulders has a market price of $7. The stock sells for $30 a share, and the option has a strike price of $25 a share. What is the exercise value of the call option? What is the option’s time value?
The exercise price on one of Flanagan Company’s call options is $15, its exercise value is $22, and its time value is $5. What are the option’s market value and the price of the stock?
Assume that you have been given the following information on Purcell Corporations call options: According to the Black-Scholes option pricing model, what is the options value?The current price of a stock is $33, and the annual risk-free rate is 6%. A call option with a strike price of $32 and with 1 year until expiration has a current value of $6.56. What is the value of a put option written on the stock with the same exercise price and expiration date as the call option?
Use the Black-Scholes model to find the price for a call option with the following inputs: (1) current stock price is $30, (2) strike price is $35, (3) time to expiration is 4 months, (4) annualized risk-free rate is 5%, and (5) variance of stock return is 0.25.
The current price of a stock is 20. In 1 year, the price will be either 26 or 16. The annual risk-free rate is 5%. Find the price of a call option on the stock that has a strike price of 21 and that expires in 1 year. (Hint: Use daily compounding.)The current price of a stock is $15. In 6 months, the price will be either $18 or $13. The annual risk-free rate is 6%. Find the price of a call option on the stock that has a strike price of $14 and that expires in 6 months. (Hint: Use daily compounding.)
8SPWhat is a financial option? What is the single most important characteristic of an option?2MCConsider Triple Play’s call option with a $25 strike price. The following table contains historical values for this option at different stock prices:
Create a table that shows (a) stock price, (b) strike price, (c) exercise value, (d) option price, and (e) the time value, which is the option’s price less its exercise value.
What happens to the time value as the stock price rises? Why?
4MCIn 1973, Fischer Black and Myron Scholes developed the Black-Scholes option pricing model (OPM). (1) What assumptions underlie the OPM? (2) Write out the three equations that constitute the model. (3) According to the OPM, what is the value of a call option with the following characteristics? Stock price = 27.00 Strike price = 25.00 Time to expiration = 6 months = 0.5 years Risk-free rate = 6.0% Stock return standard deviation = 0.496MCWhat is put–call parity?
Define each of the following terms: a. Weighted average cost of capital, WACC; after-tax cost of debt, rd(1 T); after-tax cost of short-term debt, rstd(1 T) b. Cost of preferred stock, rps; cost of common equity (or cost of common stock), rs c. Target capital structure d. Flotation cost, F; cost of new external common equity, re2Q3QDistinguish between beta (i.e., market) risk, within-firm (i.e., corporate) risk, and stand-alone risk for a potential project. Of the three measures, which is theoretically the most relevant, and why?
Suppose a firm estimates its overall cost of capital for the coming year to be 10%. What might be reasonable costs of capital for average-risk, high-risk, and low-risk projects?
Calculate the after-tax cost of debt under each of the following conditions: a. rd of 13%, tax rate of 0% b. rd of 13%, tax rate of 20% c. rd of 13%, tax rate of 35%LL Incorporateds currently outstanding 11% coupon bonds have a yield to maturity of 8.4%. LL believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%, what is LLs after-tax cost of debt?Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share with an annual dividend of $4.50 a share. Ignoring flotation costs, what is the company’s cost of preferred stock, rps?
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