CMP 298 Sample Final Solution ***ADDITIONAL NOTES AT BOTTOM*** Quantitative Questions 1.

.a) A project is expected to cost $200,000 and earn perpetual income of $20,000 at the end of every year. Set up the equation you would use to find the IRR of this project. (perpetuity) 0 = -200,000 + 20,000 IRR b) If the companys cost of capital is 12%, would you accept or reject this project? Show calculations. NPV = -200,000 + 20,000/.12 = -33,333.33 REJECT c) What is the minimum growth rate in earnings that would be required for the company to accept this project? 0 = -200,000 + 20,000/(.12-g) 200,000 = 20,000/(.12-g) 24,000 200,000g = 20,000 200,000g = 4000 g = .02

2.a) This morning a company issued a dividend for $2.00. Due to impressive market performance, dividends are expected to grow at 10% for the next three years, 8% for the year following, and level off at 5% every year from then on. If the price of one share at the end of the day was $55.00, set up the equation that would determine the rate of return being demanded by the market. *note: not 5* 2 3 4 55.00 = 2.20/(1+r) + 2.42/(1+r) + 2.662/(1+r) + 2.87496/(1+r) + 3.018708/(r-g)/(1+r)4 b) If the real return was 9%, was the stock overpriced or underpriced? P = 2.20/(1.09) + 2.42/(1.09)2 + 2.662/(1.09)3 + 2.87496/(1.09)4 + 3.018708/(.04)/(1.09)4 P = 61.61 > 55.00 - UNDERPRICED c) What would your realized rate of return be if you purchased the stock for $55.00 at the end of the day, and sold it after 4 years (and four subsequent dividends) if you did not invest the dividends after you received them? Assume the market accurately priced the stock at the time of sale. P4 = 3.018708/.04 = 75.4677 Cash received = 75.4677 + 2.20+2.42+2.662+2.87496 = 85.62466 FV = PV(1+ROR)^n 85.62466 = 55(1+ROR)^4 ROR = 11.7%

3. Three projects have the following cashflows. Year 0 1 Project A -4000 1000 B -3500 2000 C -7500 5000

2 2000 1000 1000

3 4000 1000 3000

4 0 5000 9000

5 0 1000 0

a) What is the payback period for each project? If the cut off was 2 years, which projects would be accepted? A = 2.25 B = 2.5 C = 2.5 REJECT ALL b) Assuming each project ends after 5 years and using a cost of capital of 10%, calculate the profitability index for each. If you had only $7,500 to spend, what would you spend it on? A) PV of revenues = 1000/1.1 + 2000/1.1^2 + 4000/1.1^3 = 5567.24 5567.24/4000 = 1.39 B) PV of revenues = 7431.93 7431.93/3500 = 2.12 C) PV of revenues = 13772.9713772.97/7500 = 1.84 According to PI, invest in B first, then A with leftover money. (Note: NPV of A+B is worse than C though a fault of this method) c) Set up the equation for the IRR of Project A. 0 = -4000 + 1000/(1+r) + 2000/(1+r)^2 + 4000/(1+r)^3 4. Two stocks have the following distribution of returns. Calculate the correlation between these stocks.
Return on B 2% 0.25 0.35 0.6 E(X) 6.25% 3.60% 6% 0.1 0.3 0.4

Return on A

3% 8%

0.35 0.65

A B AB

^2(X) 0.0569% 0.0384% 6% 0.1 0.3

(X) 2.385% 1.960% 0.0080%

Return on A

3% 8%

0.2330% Return on B 2% 0.25 0.35

AB 0.171 2

See equation sheet and correlation chart document for steps along the way. (Note: You should play around with the correlation chart to better understand what it means.) 5. Company XYZ is trying to determine whether or not to accept a project that requires an initial investment of $600,000 and will provide perpetual cashflows of $50,000.

Five years ago, the company issued 15-year debt with a face value of $1.7 million dollars and an annual coupon of 6%. Today the debt is priced to yield 7%. There are 175,000 common shares outstanding and 200,000 preferred shares. The preferred shares have a 5% dividend rate on a par value of $20(edited) and have a market value of $16.75. The common shares are trading at $32. The covariance of the company with the market is 0.0045 and the market variance is 12%2. The risk free rate is 3% and the market premium demanded by shareholders is 3%. Determine whether or not the company should take on the project. WACC = D/V*rd + Ep/V*rp + Ec/V*rc rd = 7% (current market yield) coupon = $1.7M * .06 = $102,000 n = 10 years left D = 102,000*(1-1.07^-10)/.07 + 1,700,000/1.07^10 = $1,580,599 P = 16.75 * 200,000 = $3,350,000 rp = D/P = ($20*.05)/16.75 = 5.97% C = 175,000 * 32 = $5,600,000 = 0.0045/(0.0012) = 3.75 rc = 3% + 3.75 (3%) = 14.25% V = 1,580,599 + 3,350,000 + 5,600,000 = $10,530,599 WACC = (1,580,599/10,530,599)*7 + (3,350,000/10,530,599)*5.97+(5,600,000/10,530,599)*14.25 = 10.53% NPV = -600,000 + 50,000/.1053 = -$125,166 REJECT

Random Theory Questions NOTE: These are by no means the 100% full mark correct answers. Please discuss theory questions with your professors. 1. Why are government bonds considered risk free? -guaranteed your money back -see notes 2. Explain the efficient market hypothesis and any underlying assumptions. -risk averse investors -public and private information -see notes 3. What is the difference between expected return and ROR? -kind of a random questiondoesnt really make senseignore? -expected return is what you predict you will get based on certain scenarios -ROR is based on the purchase of an investment and its subsequent sales a few years later 4. What are the three forms of market efficiency? Explain what form of market efficiency our economy resembles and what evidence there is or is not for each type. Weak, Semi-strong, Strong. Straight from notes. 5. Name and explain three decision rules and some advantages and disadvantages of each. See bottom left of equation sheet. NOTES from todays session: -Discuss theory questions with your professors try with your friends first, but always let the prof have the final word. -There WILL be an intense NPV problem: try Papers Paper if you havent already, and re-do Garbage Truck and XYZ again as well. Make sure you set up an accurate cashflow chart it will save your life. -There WILL be a question on how to weight your investments. Review your notes on that section and the CML line. Its a little confusing, so see if you can find questions from the textbook to test yourself. -be VERY comfortable with the CML, SML and equations there will be beta questions for sure.

GOOD LUCK!!! Its not as bad as you think!