Reference no: EM133264648

Question 1

You have been asked to value the assets of a privately-held company. You used the Capital Asset Pricing Model to estimate the equity betas for every firm in the industry and then computed the average equity beta. You noticed that firms in the industry have significantly different capital structures. You told your boss that this average beta is the appropriate beta to use for valuing the firms assets. Should your boss agree with you? Why or why not? If not, what alternative approach would you recommend? Explain.

Question 2

One of the ideas to fund the Owen School is to purchase a 50% stake in a joint venture to drill for oil on 21st Avenue. Owen will receive a payoff only if the venture strikes oil. Since the outcome of this investment is very uncertain, the opportunity cost of capital will need to be high (beta > 1) to compensate investors for this risk. Do you agree or disagree? Why or why not? Explain.

Question 3

Standard finance theory predicts that management should maximize the value of the firm by selecting investment projects whose NPV is positive and rejecting projects whose NPV is negative. Consider an all-equity firm. Under what conditions might management incorrectly apply the CAPM such that they accept negative NPV investments or reject positive NPV investments? Explain.

Question 4

We determined that the price of a call option depends on five variables; (a) stock price, (b) exercise price, (c) time to expiration, (d) volatility of the stock, and (e) the risk-free rate. Now consider the price of a put option. How would you expect the price of a put option to change with an increase in each of the following factors? Complete the following table.

Question 5

A project has perpetual cash flows of $C per year beginning next year, an initial investment of $Inv, and an IRR or r%. What is the relation between the projects payback and its IRR? Demonstrate algebraically. What implications does your answer have for long-lived projects with relatively constant cash flows? (Hint: Recall the definition of the IRR for an investment, and let t=payback number of years.)

Question 6

(1) A firm is considering an investment that will produce annual revenues of $1,250,000, require variable costs of $500,000 per year, and will have relevant fixed costs of $200,000 per year (these fixed costs do not include depreciation.) All receipts and payments begin one year from today and end five years from today. The production equipment purchased at date 0 is depreciated to a zero book value with no hope of selling the equipment at end of the project.

Assume that the total present value of the after-tax cash flows from operations is $1,762,716. If the opportunity cost is 10% and the corporate tax rate is 35%, what is the annual depreciation charge and the original cost of the equipment? Show your work for partial credit.

Question 7

(2) A project will have annual sales of $100 beginning in one year. Sales will remain constant forever. Costs will be $54 in one year and will increase by 8% every year thereafter. Ignoring taxes, what is the maximum possible total NPV of the project if the discount rate is 10%. Assume that management has the discretion to discontinue the project at any time.

Question 8

(3) You own equity in a firm whose asset beta is 0.50, and whose assets are partially funded with risk-free debt. The market value of the equity is $15 million and the market value of the debt is $10 million. If the equity beta of the firm's stock is equal to the beta of a portfolio comprised of one-third Treasury Bills and two-thirds of the market, what is the firm's debt-equity ratio? Show your work.

Question 9

(4) You have been hired as a consultant by Vogus Corporation and have been asked to evaluate their capital budgeting procedures. They provide you with a list of recently accepted projects, and you learn that the firm accepts investments whose payback period is 5 years or less. You read that one of the accepted projects had an initial cost of $1,200. All cash flows except the initial investment are non-negative cash inflows. If the appropriate discount rate is 20% per year, what is the worst-case NPV for this project? Show your work.

Question 10

(5) Recall our in-class example of a call option with an exercise price of $100, current stock price of $100 and a risk-less rate of 5%. Next period, the stock would be worth either $110 or $90. Under these conditions, we found that the option value was $7.143. What is the price of the option if the distribution of the stock prices next period is $80 and $120 when all other inputs are equal to their original values? What is the relation between option prices and changes in the volatility of the underlying stock price?

Question 11

(6) Suppose that the current price of a stock is $60. The expected dividend at date one is $20 and the expected dividend at date two is $10. If the opportunity cost of capital is 10% per year, can you estimate the expected stock price at date two? If so, what is the expected price at date 2? If not, what other information would you require to estimate the price at date two?