Problem 1. Your firm and a possible project have the following cash flows:
Company Project
Economy good bad good bad
Year 0 -200 -200 -50 -50
Year 1 100 50 20 60
Year 2 120 60 30 50
Year 3 110 55 40 90
Year 4 90 45 35 70
Given 8% discount rate, a 60% chance of a good economy over the next 4 years, and a 40% chance of bad economy, what are the expected net present value and standard deviation of net present value for the company, for the project, for the combination of the company and the project?
Problem 2. Wyoming Processing has expected annual sales of $1,200,000. Fixed cash costs are $100,000 and variable cash costs are 70% of sales. A new capital investment with a 10-year life will require an after tax cash outlay of $100,000. The result will be a change in production methods that increase fixed costs to $200,000 a year and reduce variable costs to 60% of sales. The required return is 10% and all cash flows are after tax (assuming year-end cash flow for simplicity). (a) Does the capital investment have a positive net present value? (b) Find the cash flow breakeven point for the company with and without the capital investment.
Problem 3. Klemkosky is considering the acquisition of a privately held company. The company's equity can be purchased for $1.2 million in cash and is expected to generate after tax cash flows of $250,000 a year for 10 years, with no terminal value. The acquisition candidate is financed with 60% debt and 40% equity. The interest rate on the debt is 8% and the risk-free rate is 6%. The tax rate is 34%. Companies in the same industry as the acquisition candidate have un-leveraged betas of 0.9. Should KlemKosky make the acquisition? Return on a market portfolio is 12.5%.
Problem 4. Michigan Corporation is expected to have earnings per share of $10 over the next year. Dividends are expected to be kept at 60% of earnings, and retained earnings are expected to be invested at a 14% rate of return. The price of the stock is presently $40. What is the anticipated growth rate of dividends, and what is the cost of existing equity (Hint: remember that g = return on reinvested equity * retention ratio)?