Q1. Answer the following two questions with short answers. a) Su...

Q1. Answer the following two questions with short answers.

a) Suppose you believe that the CEO’s height is a good indicator for the expected future returns of the company’s stock. Is your belief consistent with the Capital Asset Pricing Model (CAPM)? Why or why not?

b) Suppose the ACME Corporation’s stock has a zero market beta. Does this mean that this security has no risk? Explain briefly.

Q2. Suppose that Niagra Housing Resources (NHR) is a company that has both debt and equity trading in markets. The firm’s current market value of equity is
$43,900,000 and the market value of its debt is $20,987,000.

You may assume the risk-free rate of return is 1% and the expected return of the market portfolio is 6%. The firm’s beta is 1.91.

The firm has twenty thousand bonds outstanding which mature 2 years from now. Each bond has a face value of $1000 and an annual coupon rate of 6.75%. A coupon payment has just been paid.

The company is currently facing an investment opportunity with risk equivalent to the company’s current operations. The project has an initial cash inflow of
$130,000, and the project is expected to have perpetual cash outflows after the initial date such that the internal rate of return on this project is 9.5%.

Ignore depreciation, and assume that the current capital structure will remain constant. If the tax rate is 34%, decide whether the company should proceed with this project using the internal rate of return criterion and the net present value criterion. Decide what the company would be willing to pay for the project if the initial cash flow becomes negotiable in the future.

Q3. For each of the following parts, write down the strongest market efficiency concept that you can’t rule out with the given information.

a) A family member of a HighGene Pharmaceuticals executive strangely sells all of her shares at the market price on day 1. Without the existence of any news (including the sale) that can affect the stock price in between, the stock trades at a similar price until day 10 when the news arrives that the company’s only product was not approved by the FDA. The stock price drops 90% as the information is revealed to investors.

b) The High Octane Company’s production plant was destroyed in a fire on June 22nd. The Company’s press consultant appears on TV on June 23 stating the exact amount of loss, and adds that the company had no insurance coverage for the assets. After a week without any other news relating to the company, wherein the stock price maintained its June 21st value, the stock price of the company plummets on June 27 (you may assume that the markets were open every day during this period).

c) A friend of yours states that her technical analysis methods, which use past information about the stock prices, work perfectly well and she can predict the level of the stock market the next day. Suppose that she is right every day.

Q4. Lucia’s Top Chops (LTC) is a haircutting chain. The management team at the company has decided to estimate the firm’s financing needs for the next five years. LTC has decided to project future (pro-forma) income statements and balance sheets using the following assumptions:
• Cost of goods sold is 79% of sales.
• Sales general and administrative expenses are 6% of sales.
• Current assets, current liabilities, and net fixed assets are the same ratio to sales as they were in the previous year.
• Depreciation expense is 19% of current year gross fixed assets.
• The interest rate on the firm’s debt is 3% of the previous year’s debt.
• The interest earned on marketable securities is 2% of the previous year’s marketable securities.
• The corporate tax rate is 35%.
• The dividend payout ratio is 10%. (i.e. 10% of net income is paid to shareholders in the form of a dividend)
Suppose the current year sales at LTC are $16,550,000.00. The company plans no new net issues of stock. The company’s current balance sheet is given in the downloadable template. Construct pro-forma income statements and balance sheets for the next five years. Assume the firm has either marketable securities in a given year or debt, but not both. For simplicity, assume the firm will pay negative dividends if profit after tax is negative. Then answer the following:

a) If there is no growth, will the firm have marketable securities at the end of the fifth projected year? If so, how much will the marketable securities be worth? If not, how much debt will there be?
b) What is the maximum constant rate of growth in sales that will allow the company to obtain a debt-to-equity ratio of 0.35 or less at the end of the fifth projected year?
c) If the firm has a constant dollar growth (i.e., each year's growth is a fixed percentage of initial sales), what percentage would allow the company to obtain a debt-to-equity ratio of
0.1 or less at the end of the fifth projected year?
d) Suppose that LTC’s costs of goods sold decrease in the third projected year from 79% to 73% of sales, and the decrease is permanent. How does your answer to part (b) change?

Q5. Consider two projects. Project A requires an initial investment of $20,500, and it returns $10,000 and $10,000 and $11,000 at the end of the first, second and third years, respectively. Project B has an initial cost of $18,000, and then returns $24,000, $1,100 and $1,100 in each of the following three years.

a) Compute the Internal Rate of Return (IRR) for each project.
b) Which project would you choose?

Q6. Assume you learned about the future states of the world and their probabilities of occurring. The table below gives the expected market return and expected prices of two individual stocks in each state. The current prices of Stock 1 and Stock 2 are $20 and $35, respectively. You can ignore dividends.

State of the world, Probability of state, Expected Market Return, Expected Price of Stock 1, Expected Price of Stock 2
A .15 -2.1% 19 30
B .20 1.8% 21 54
C .45 8.3% 22 43
D .20 14.6% 22 49

a) Which individual stock (1 or 2) would you choose? (Why?)
b) What are the betas of stocks 1 and 2?
c) What is the beta of a portfolio consisting of 35% of stock A and 40% of stock B and 25% of risk-free asset?

Q7. A new machine lasts 3 years and has a purchase price of $10,000. It costs
$4000 per year to operate and has a salvage value of $1,500 at the end of the 3- year period. The discount rate is 12%. What is the Equivalent Annual Cost (EAC) of the new machine? Assume operating costs are paid at the end of each year. Ignore taxes.