Reference no: EM132649075

Case 1  Situation

Sam Wesley is the finance director of True North Investment Management. He is designing the company's pension fund management products. A important new client, Super Phone has requested that True North present an investment seminar to its executive committee, the topic is about long-term corporate bonds. Sam, who will make the actual presentation, have asked you, a recent graduate, to help him by answering the following questions:

a. What are the key features of a bond?

b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?

c. Describe DCF. How is the value of any asset whose value is based on expected future cash flows determined?

d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?

e. What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by 4 percentage points, causing investors to require a 14 percent return? Would we now have a discount or a premium bond? How about if the investors require a 8 percent return?

f. What is the yield to maturity on True North's bond, assume it is a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond's coupon rate? What is the yield-to-maturity of the bond?

g. How does the equation for valuing a bond change if semiannual payments are made by True North? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd = 13%.

h. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF?

i. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 30-year bond? Why?

j. Briefly describe bankruptcy law. If a firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?

Case 2

Situation

Assume that you recently graduated with MBA major in finance, and you just landed a job as a financial planner with East Fintech Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1 year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associtated outcomes.

State of Economy	Probability	T-Bills	BC Inds.	Van	Canadian Steel	Market Port.	2-Stock Portfolio
Recession	0.1	7.00%	-20.00%	25.00%	8.00%	-13.00%	3.00%
Below Average	0.3	7.00%	-2.00%	16.50%	18.00%	1.00%
Average	0.3	7.00%	18.00%	0.00%	6.00%	15.00%	10.00%
Above Average	0.2	7.00%	32.00%	-8.50%	40.00%	30.00%
Boom	0.1	7.00%	55.00%	-18.00%	25.00%	40.00%	15.00%

East Fintech's economic forecasting staff has developed estimates for the state of the economy and its security analyst have developed a sophisticated computer program which was used to estimate the rate of return on each state of the economy. BC Industries, Inc. is an electronics firm; Van Inc. collects past due debts; and Canadian Steel manufactures cookware products. East Fintech also maintains an "TSX fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions.

Return on Investment

a. What are investment returns? What is the return on an investment that costs $1,000 and is sold a year later for $1,100?

Investment return measures the financial results of an investment. They may be expressed in either dollar terms or percentage terms.

b.Why is the T-bill's return independent of the state of the economy? Do T-bills promise a completely risk-free return?

c. Calculate the expected rate of return on each alternative.

d. Calculate the standard deviation for each stock. Why is the standard deviation of returns onne possible measure of risk?

e. Suppose you created a 2-stock portfolio by investing $50,000 in BC Inds. and $50,000 in Van.
(1.) Calculate the expected return and the standard deviation of the portfolio,

(2.) How does the risk of this 2-stock portfolio compare with the risk of the individual stocks if they were held in isolation?

f. Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen (1) to the risk and (2) to the expected return of the portfolio as more and more randomly selected stocks were added to the portfolio? What is the implication for investors? Draw a graph of the two portfolios to illustrate your answer.

h. Should portfolio effects impact the way investors think about the risk of individual stocks?

i. How is risk measured for individual securities? How are beta coefficients calculated?

j. Explain the Security Market Line (SML) equation, If a company's beta were to double, would its expected return double?

Case 3
During the last few years, Harrison Henry Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Marvin Patrick, the financial vice-president. Your first task is to estimate Harrison Henry' cost of capital. Marvin has provided data that he believes is relevant to your task.

(1) The firm's tax rate is 38%

(2) The current price of Harrison's 10 percent coupon, semiannual payment, noncallable bonds with 12 years remaining to maturity is $1282.76.

(3) The current price of the firm's 7 percent, $28 par value, quarterly dividend, perpetual preferred stock is $15.86. Harrison would incur flotation costs equal to 6 percent of the proceeds on a new issue.

(4) Harrison' common stock is currently selling at $45 per share. Its last dividend (Do) was $2.20, and dividends are expected to grow at a constant rate of 6% in the foreseeable future. Harrisons' beta is 1.15, the yield on T-bonds is 3 percent, and the market risk premium is estimated to be 7.5 percent.

(5) Harrisons' target capital structure is 35 percent long-term debt, 10 percent preferred stock, and 55 percent common equity.

(6) Harrison does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation costs.

To structure the task somewhat, Marvin has asked you to answer the following questions.

a. What is the market interest rate on Harrisons' debt and its component cost of debt?

b. (1.) What are the two primary ways companies raise common equity?

(2.) Why is there a cost associated with reinvested earnings?

c.Harrisson doesn't plan to issue new shares of common stock. Using the CAPM approach, what is Harrisons' estimated cost of equity?

d. What is your final estimate for the cost of equity, rs?

e. What is Harrisin' sweighted average cost of capital (WACC)?

f. What factors influence a company's WACC?

g. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division's beta?

h. Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reinvesting earnings.

i. (1.) Harrison estimates that if it issues new common stock, the flotation cost will be 15 percent. Harrison incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued stock, taking into account the flotation cost?

j. What common mistakes in estimating the WACC should Harrison avoid?