Question1) Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The product is expected to generate profits of $1 million per year for 10 years. The company will have to provide product support expected to cost $100,000 per year in perpetuity. Assume all profits and expenses occur at the end of the year.
a) What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project?
b) Can the IRR rule be used to evaluate this investment? Explain!
Question2) Suppose Intel’s stock has an expected return of 26% and a volatility of 50%, while Coca Cola’s has an expected return of 6% and volatility of 25%. Further, assume that these two stocks are perfectly negatively correlated (i.e., their correlation coefficient is −1).
a) Calculate the portfolio weights that remove all risk
b) If there are no arbitrage opportunities, what is the risk-free rate of interest
Question3)
a) How can we examine, using empirical data, whether the market is efficient. Describe carefully the research setting.
b) How can we examine using empirical data whether the strong form of market efficiency holds. Describe carefully various research settings. c) Why do firms rely heavily on internal funds? Put differently, why do firms rather not issue stock to finance a project?
Daboera Inc. is considering the launch of a new hybrid car, GREEN.
• GREEN is expected to sell 100,000 units for 2 years. (That is, 100,000 in year 1 and 100,000 in year 2)
• The retail price is €200.
• The cost to produce a single unit of GREEN is €80.
RED, which is an older model of Daboera Inc would have sold 20,000 units in year 1 and 20,000 units in year 2 for €150. However, the introduction of GREEN will reduce the sales of RED by 25%. The cost to produce a single unit of RED is €100.
a) Calculate the incremental gross profit for each year (i.e., calculate the change in gross profit as a result of the introduction of GREEN).
For the following questions assume the following facts:
• The R&D costs of GREEN are €2.5 million and paid upfront (i.e., in year 0). Note that the firm should expense R&D costs as incurred to comply with the financial standards.
• Daboera Inc. will spend €3.25 million on marketing to increase consumer awareness during year both 1 and 2.
• Storage of GREEN parts requires the use of a warehouse, which the firm already owns. This warehouse could be rented out for 500,000 per year during year both 1 and 2.
• Production of GREEN requires an upfront investment of €9 million in order to buy the needed equipment. For tax purposes we need to assume that the equipment has a three-year life and that the firm uses straight-line depreciation for the new equipment.
• Income tax is 40%.
• Daboera Inc. is not allowed to carry forward or carry back losses. Therefore, negative taxes are assumed to be cash inflows (at the end of the year).
• Revenues and costs are paid at the end of the year.
b) Calculate the incremental unlevered income (income after taxes, assuming that the project is equity-financed). For the following questions assume the aforementioned and the following facts:
• Net working capital each year is 20% of gross profit.
• The opportunity cost of capital is 12%
c) Should Daboera Inc. accept or reject the project? Motivate your answer by calculating the Net Present Value.