I know I should be feeling a wave of relief right now, but I know I failed my final for Financial Management. Here's a peek at a few of the problems I spent over 20 hours on (enjoy doing them, Robert):
2. (16 points). The standard deviation of returns on Carlson company’s common stock is 37%, and Carlson’s beta coefficient is 0.9. Currently, yields on Treasury Bills are 5.5%, while the average yield on Treasury Bills over the past seventy years has been 3.7%. The standard deviation of market returns is 22%. The return on the overall market last year was 10.2%, while the average market return over the past seventy years has been 12.2%.
(a) (8 points) Provide an estimate of the expected return on Carlson common stock, and explain the reasoning behind the estimate.
(b) (8 points) Carlson has 2.2 million shares of common stock outstanding. The common stock has a book value of $9 per share, and sells in the market for $12 per share. Carlson also has debt with a face value of $18 million outstanding. The debt pays coupon interest rate of 9.5%, but sells in the market for 110% of its face value, and has a yield-to-maturity of 8.8%. Carlson’s corporate income tax rate is 35%. Compute Carlson’s weighted average cost of capital (WACC).
5. (14 points) TLP corporation had operating cash flow of $3.20 per share last year, and has 1.5 million shares outstanding. Given TLP’s existing asset base, this level of cash flow can be sustained forever. TLP has existing liabilities with a market value of $3 million.
(a) (5 points) If TLP has no other assets, and a discount rate of 13% per year is appropriate, what is the fair market value of a share of TLP stock?
(b) (9 points) Assume now that TLP has just made a breakthrough in biomedical engineering. The new project will require an immediate capital expenditure of $2.5 million, plus another $2.5 million outlay after one year. At the end of the second year the project will generate positive cash flow of $1.1 million. Subsequent cash flows from the project will grow by 4% per year in perpetuity. Given that TLP has made this breakthrough, and still assuming a 13% discount rate, what is the fair market value of a share of TLP stock?
7. (20 points) Jensen Company owns a building in a suburban industrial park. It purchased the building four years ago for $3 million. It is now deciding whether to lease the building or to use it as a distribution center. It could be rented immediately. Given today’s market conditions, rental income of $120,000 per year would be expected. To convert the building to make it useful as a distribution center would require an immediate expenditure of $400,000. Having the distribution center at this location would provide Jensen with $140,000 per year in cost savings, at today’s prices. The cash flows associated with this decision are not very risky, so a real discount rate of just 3% per year is required.
For simplicity, assume that: (i) there are no taxes, (ii) the building could be rented or used as a distribution center forever, (iii) ongoing cash flows, including rents and distribution cost savings, would increase with the overall inflation rate, and (iv) all cash flows except the initial $400,000 would occur at year end. (the last assumption implies that one year of inflation would affect the first lease payment and distribution cost saving)
(a) (4 points) The inflation rate is forecast to be 4% per year. What nominal discount rate is appropriate for this project?
(b) (8 points) Provide a NPV analysis and a recommendation of how the building should be used.
(c) (4 points) Is the outcome of your NPV analysis sensitive to changes in the assumed inflation rate? (An intuitive answer without numbers is OK).
(d) (4 points) Based on the information provided, is it possible to estimate the current market value of the building? If so, provide an estimate.
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