Reference no: EM13139738

PART A. (10 marks) 
You have been asked to analyse Grand Plomp Ltd, a maker of rocket widgets used by NASA. The owners are wondering whether the return received is sufficient to justify the risks taken in each division. You are to consider both divisional risk and return in your analysis and the following information has been collected from the past fifteen years to use in your n your analysis. 

Percent Risk Measure % Average
Division of Rocket Standard Beta Annual Rate
Widgets Deviation of Return (%)
A 10 12 1.1 10
B 20 36 1.2 20
C 30 14 0.8 8
D 40 15 0.9 15

• Average annual market return: 12 per cent 
• Average annual risk-free rate: 8 per cent 

Using standard deviation and beta measures of risk, you are to rank projects in terms of their risk-adjusted return. Those divisions providing the lowest risk per unit of return would be preferred. An analysis can be conducted using a 'total' definition of risk, or standard deviation, and an 'undiversifiable' definition or risk, or beta. 

Given the beta, it is possible to measure the required rate of return. Furthermore, given the proportion of each division within Global Gears, it is possible to calculate the firm beta, return and risk-adjusted return. With this information, it is possible to determine whether Global Gears, as a whole, provides a sufficient return to justify the risks taken by its investors. 
You are required to: 
• Locate the relevant information 
• Select the proper tool or equation 
• Organise and manipulate the data 
• Explain the solution 

PART B (12.5 marks) 

Misty Ltd wishes to determine its weighted marginal cost of capital. In preparing for this task, it has compiled the following data: 

Source of Capital Target Range of Financing After-Tax 
Proportion $ $ Cost
Long-Term Debt 0.4 0 to 300,000 0.065
300,001 to 600,000 0.075
600,001 and above 0.090
Preference Shares 0.1 0 to 100,000 0.095
100,001 and above 0.100
Ordinary Shares 0.5 0 to 500,000 0.11
500,001 to 1,000,000 0.125
1,000,001 and above 0.14

a) Determine the breaking points and ranges of total financing associated with each source of capital;
b) Using the data developed determine the levels of total financing at which the firm's weighted average cost of capital (WACC) will change;
c) Calculate the weighted average cost of capital and the weighted marginal cost (WMCC) for each range of total financing
d) Using the results along with the information on the available investment opportunities shown below, compile the firm's investment opportunities schedule (IOS), plot this schedule and plot the weighted marginal cost of capital schedule 

Investment Opportunities Schedule 
Investment IRR Initial 
Opportunity Investment 
A 0.14 200,000 
B 0.12 300,000 
C 0.11 500,000 
D 0.1 300,000 
E 0.09 600,000 
F 0.08 100,000 

e) Which, if any of the available investments would you recommend that the firm accept? Explain your answer. 

PART C. (7.5 marks) 

Traditional project evaluation/capital budgeting analysis assumes a firm's only choice is accept or reject a program. In a real business situation, firms face many choices with respect to how to operate a project, both before it starts and after it is underway. Any time a firm has the ability to make choices, there is value added to the project in question - Traditional NPV analysis ignores this value. The study of real options attempts to put a dollar value on the ability to make choices. 

a) What are real options and how are they valued. 

b) Discuss the following 

Locate the following article 
IRREVERSIBILITY, UNCERTAINTY, AND INVESTMENT 
(Robert S Pindyck - Massachusetts Institute of Technology March - 1990 - old but gold) 

Most major investment expenditures have two important characteristics which together can dramatically affect the decision to invest. First, the expenditures are largely irreversible; the firm cannot disinvest, so the expenditures must be viewed as sunk costs. Second, the investments can be delayed, giving the firm an opportunity to wait for new information about prices, costs, and other market conditions before it commits resources. 


c) Calculate the following 

Pindyck supplies a simple two-period example to illustrate how irreversibility can affect an investment decision and how option pricing methods can be used to value a firm's investment opportunity, and determine whether or not the firm should invest. 

Using the following example replicate Pyndick's two-period example. 

Consider a firm's decision to irreversibly invest in a widget factory. The factory can be built instantly, at a cost of $7m, and will produce 1000 widgets per year forever, with zero operating cost. Currently the price of widgets is $700, but next year the price will change. With probability .6 it will rise to $800, and with probability (l-q) it will fall to $600. The price will then remain at this new level forever. Assume that this risk is fully diversifiable, so that the firm can discount future cash flows using the risk-free rate, which we will take to be 10 percent.