FIN 3104 Lecture Notes - Lecture 3: S&P 500 Index, Cash Flow, Sunk Costs
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The following Balance Sheet extract relates to the Snapple Company:
Bonds payable $1,000,000
Common Stock $3,000,000
Preferred Stock $2,000,000
Additional Information:
The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.
The companyâs common shares which have a book value of $25 per share are currently selling at $20 per share.
The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%
The preferred dividends are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.
The Companyâs tax rate is 35%.
Required:
a) Calculate Snappleâs cost of debt. [5 marks]
b) Calculate Snappleâs cost of equity. [5 marks]
c) Calculate Snappleâs cost of preferred shares. [3 marks]
d) Calculate Snappleâs Weighted Average Cost of Capital [8 marks]
e) Explain why the cost of debt is cheaper than the cost of equity. [3 marks]
f) Explain why the cost of retained earnings is equivalent to the cost of an existing issue of common stock. [4 marks]
g) Outline two (2) reasons why a firmâs cost of capital is critically important. [2 marks]
2.
The Beacon Inc. is considering two mutually exclusive projects, each with an initial investment of $150,000. The companyâs board of directors has set up a 4-year payback requirement and has set its cost of capital at 9%. The cash inflows associated with the two projects are as follows:
| Year | Cash Inflows (CFt) | ||
| Project A | Project B | ||
| 1 | $45,000 | $75,000 | |
| 2 | $45,000 | $60,000 | |
| 3 | $45,000 | $30,000 | |
| 4 | $45,000 | $30,000 | |
| 5 | $45,000 | $30,000 | |
| 6 | $45,000 | $30,000 | |
a) Calculate the payback period for each project. [2 marks]
b) Calculate the NPV for each project at 7% and 9%. [6 marks]
c) Based on b) above which project would you choose and why.[ 2 marks]
d) Briefly explain why firms engage in âcapital rationingâ [2 marks]
e) What are Real Options? What are some major types of real options? [3 marks]
3.
The Lifeâs Good Corporation 2012 income statement shows the following:
|
Income Statement 2012 | |
| Sales | $ 5,250,000 |
| Costs | 2,173,000 |
| Other expenses | 67,400 |
| Depreciation expense | 179,000 |
| EBIT | $ 2,830,600 |
| Interest expense | 85,555 |
| EBT | $ 2,745,045 |
| Taxes | 89,000 |
| Net income | $ 2,656,045 |
| Dividends | $ 169,000 |
| Addition to retained earnings | $ 2,487,045 |
Lifeâs Good Corp. also issued $106,700 in new equity during the year and redeemed $65,300 in outstanding long-term debt.
i. Calculate the operating cash flow for the firm. (2 marks) $2,920,600
ii. Calculate the cash flow to creditors. (2 marks) $150,855
iii. Calculate the cash flow to stockholders. (2 marks) 62,300
iv. Define free cash flow (FCF) and state one of the equations for computing FCF. (3 marks)
4.
Clarkâs Drug Store, a medium-size drugstore located in Bridgetown Barbados, is owned and operated by Robert Clark. Clarkâs sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Clarkâs most recent annual net income statement is as follows:
| Sales Revenue | $2,600,000 |
| COGS | 1,460,000 |
| Wages and Salaries | 250,000 |
| Rent | 190,000 |
| Depreciation | 70,000 |
| Utilities | 95,000 |
| Miscellaneous | 30,000 |
| Total Expenses | 2,095,000 |
| Net Profit before Tax | 505,000 |
Clarkâs sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Clarkâs is considering using some floor space for a small soda fountain. Clarkâs would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $85,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down.
The soda fountain is expected to have annual sales of $670,000 and food and materials expenses of $380,000 per year.
The soda fountain is also expected to increase wage and salary expenses by 6% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.
Calculate net incremental cash flows for the soda fountain. (6 marks)
ii. Assume that Clarkâs has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not? (4 marks)
5. âIn order for a project to be acceptable, its required rate of return must exceed the cost of debtâ. Do you agree? In light of the statement, define what is cost of capital and what role does it play in long-term investment decisions? (5 marks)
6. What do you understand by the term net proceeds in context with a bond sale? How do floatation costs affect the net proceeds? (3 marks)
7. Go-geta Corp. issued 10-year bonds 2 years ago at a coupon rate of 6 percent. The bonds make semiannual payments. If these bonds currently sell for 98 percent of par value, what is the YTM? (2 marks)
| FV | $1000 |
| PV | $ (980.00) |
| Coupon | $ 30.00 |
8. ABC Company has an unusual dividend policy. The company has just paid a dividend of $5 per share and has announced that it will increase the dividend by $2 per share for each of the next four years, and then never pay another dividend. If you required a 9 percent return on the companyâs stock, how much will you pay for a share today? (5 marks)
| Dividend D0 | 5.00 | ||
| Div increase yrly | 2.00 | ||
| Required return | 9.00% | ||
| Stock Price | |||
| Factor | Price | ||
| D (1) | 1.09 | 5.00 | 4.59 |
| D (2) | 1.1881 | 7.00 | 5.89 |
| D (3) | 1.295029 | 9.00 | 6.95 |
| D (4) | 1.411582 | 11.00 | 7.79 |
9 âWhile contemplating to create a portfolio, it is imperative to study the correlation amongst the assets that constitute the portfolioâ. Discuss the statement and explain how diversification helps in reducing the risk of the portfolio as compared to the individual risks of constituting assets. (5 marks)
