Posted: September 18th, 2017

# Solutions

Week 5 Problems—Solution Ranges, AMBA 630

For this problem set, we are not going to give you the exact answer but a range within which the correct answer can be found.  For example, if the problem was “How much is 20 plus 50?” we would say, “The correct answer is between 65 and 75” and you would need to specify the exact answer of “70.”

1. The corporate treasurer of Rollinsford Company expects the company to grow at 3% in the future, and debt securities at 4% interest (tax rate = 35%) to be a cheaper option to finance the growth. The current market price per share of its common stock is \$39, and the expected dividend in one year is \$1.50 per share. Calculate the cost of the company’s retained earnings and check if the treasurer’s assumption is correct.

Range: the cost of debt is somewhere between 2% and 5%.  Please specify the exact answer.  The cost of retained earnings is somewhere between 6.0% and 8%.  Please specify the exact answer.
Point value: 5%

2-A       The risk-free rate on 30 year U.S. Treasury bonds is 3.25% and the expected rate of return on the overall stock market is 12%. The company has a beta of 1.6. What is the cost of equity?                                                                                                                                                                                                                                                          Range:    Between 14% and 22%

Point Value    3%

2-B       Les argues that the 10 year note is a better risk free rate at 2%. He also argues that the stock market is too high and the expected return is really only 5%. Assume that he is correct. The company has a beta of 1.6. What is the cost of equity?

Range: Between 4% and 9%

Point Value    7%

1. A company, West Berwick Enterprises, has a capital structure as follows:            Total Capital                       \$1,000,000
Debt                            \$400,000                                                                    Preferred Stock           \$100,000                                                                    Common Equity          \$500,000
What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital? Assume the applicable tax rate is 40%, interest on debt is 7%, flotation cost per share of preferred stock is \$0.75, and flotation cost per share of common stock is \$4. The preferred and common stocks are selling in the market for \$26 and \$143 a share respectively, and they are expected to pay a dividend of \$1.50 and \$4.50, respectively, in one year. The company’s dividends are expected to grow at 7% per year. The firm would like to maintain the existing capital structure to finance the new project.

Range: Between 4% and 9%

Point Value   15%

4..        West Berwick is considering two projects for a new investment, but it can afford only one. It has determined that the appropriate discount rate is 7.39%. Please answer the following questions based on the data below:

Net Cash Flow

Year

Project A            Project B

0         -\$4,000,000     -\$5,000,000

1         \$800,000         \$1,900,000

2         \$1,000,000      \$1,700,000

3         \$1,200,000      \$1,400,000

4         \$1,400,000      \$900,000

5         \$1,600,000      \$300,000

4-A      Calculate the payback period for each project.

Range: For Project A, the answer is somewhere between 2 and 5 years. Please specify the exact answer.  For Project B The answer is somewhere between 2 and 5 years. Please specify the exact answer.

Point Value    6%

4-B      Calculate the net present value for each project.

Point Value     6%

4-C      Which project do you think will be approved, if only one project can be approved? Why?

Range:  Project A or Project B  Specify your choice
Point Value   3%

4-D       What if the required rate of return was 10%?

Point Value   6%

4-E      What is the Internal rate of return?

Point Value    6%

4-F.      Which is the best to use for deciding: Payback, NPV or IRR? Why?

Point Value     8

1. A corporate bond has a face value of \$1,000 and an annual coupon interest rate of 7%. Interest is paid annually. 10 years of the life of the bond remain. The current market price of the bond is \$1232. To the nearest 1/100 0f 1 percent, what is the yield to maturity (YTM) of the bond today? Range: The answer is somewhere between 2% and 7%. Please specify the exact answer.

6-A       Kennebunk Manufacturing is expected to pay a dividend of \$8 per share next year.  The dividend growth rate is expected to continue to be 3%. Required rate of return is 7%. What should be the current market price per share?

Point Value   6

6-B.      If you buy the stock in Kennebunk (above) at \$185 and the stock price grows at the expected rate, What would be your percent return after one year?

Point Value    6

1. On January 15, 2013, A common stock sells for \$82 per share, has a growth rate of 7% and a dividend that was just paid of \$3.82 in December 2012. What is the annual percent yield per share?

Point Value    6

1. 8. A corporate bond has a face value of \$1,000 and an annual coupon interest rate of 6%. Interest is paid annually. 12 years of the life of the bond remain. The current market price of the bond is \$1,127, and it will mature at \$1,000. To the 1/10 percent, what is the yield to maturity (YTM) of the bond today?

Point Value    6

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