1. (Short Answer Questions: 8 points, 2 points each part). (a) Ericson Corporation’s total assets are projected to increase by $30 million next year. Ericson is also scheduled to repay $14 million in...

1. (Short Answer Questions: 8 points, 2 points each part).

(a) Ericson Corporation’s total assets are projected to increase by $30 million next year. Ericson is also scheduled to repay $14 million in debt next year. Other than this repayment, no changes in liabilities are currently scheduled. Ericsons’s income is projected to be $4 million, half of which will be paid as a dividend. What is the amount of Ericson’s External Funds Needed (EFN) for next year?

(b) Ericson’s $4 million net income consists of $33 million in revenues, less $25 million in various cash-based costs, and $4 million in depreciation expense. Also, of the $30 million increase in assets, $2 million is attributable to an increase in inventory and receivables. No other changes in working capital are anticipated. What is the amount of Ericson’s operating cash flow?

(c) Evaluate the following statement: In order to maximize shareholder value, it is important that the company always select those investments that provide the highest internal rate of return.

(d) Evaluate the following statement: In order to maximize shareholder value, it is important that the company select projects whose payoffs have low correlations with each other, since this reduces the risk of the company.

2. (12 points). The standard deviation of returns on Carlson company’s common stock is 37%, and Carlson’s beta coefficient is 0.9. Currently, yields on Treasury Bills are 5.5%, while the average yield on Treasury Bills over the past seventy years has been 3.7%. The standard deviation of market returns is 22%. The return on the overall market last year was 10.2%, while the average market return over the past seventy years has been 12.2%.

(a) (6 points) Provide an estimate of the expected return on Carlson common stock, and explain the reasoning behind the estimate.

(b) (6 points) Carlson has 2.2 million shares of common stock outstanding. The common stock has a book value of $9 per share, and sells in the market for $12 per share. Carlson also has debt with a face value of $18 million outstanding. The debt pays coupon interest rate of 9.5%, but sells in the market for 110% of its face value, and has a yield-to-maturity of 8.8%. Carlson’s corporate income tax rate is 35%. Compute Carlson’s weighted average cost of capital (WACC).

3. (10 points, 2 points each part) Consider the following three investments. Listed are the possible returns on each. For simplicity we’ll assume that there are only three possibilities, and that they are equally likely.

(a) What is the expected return on each asset?

(b) What is the expected return on a portfolio with 50% of funds in M and 50% in I?

(c) What is the expected return on a portfolio with 50% of funds in M and 50% in A?

Based on this probability distribution, the standard deviation of Asset M returns is 19.03%, the standard deviation of asset I returns is 21.28%, and the standard deviation of Asset A returns is 26.19%. The correlation between M and I returns is -.981 while the correlation between M and A returns is .997.

(d) Consider two portfolios. The first has 50% of funds in Asset M and 50% in Asset I. The second has 50% of funds in Asset M and 50% in Asset A. Which portfolio is less risky, and why? (Answer this question based on principles discussed in class, without referring to actual risk outcomes – these will be addressed in the next part of the question).

(e) What, specifically, are the return standard deviations on the two portfolios described in (d)?

4. (8 points, 2 points each part) You are considering investing in the SPY Exchange Traded Fund. This fund delivers returns that closely track the S&P 500 Stock Index. While the rate of return that the SPY will deliver in the future is uncertain, the mean or expected return is 7% per year. Your initial plan was to invest $50,000, using your own money. However, your broker says that she will loan you another $50,000 at a 4% interest rate, thereby allowing you to invest $100,000 in the SPY. (Just as an FYI, this is known as purchasing stock on margin).

The following questions can be answered conceptually without numbers, though it is possible to supply numbers if you wish.

(a) Is the expected rate of return on your $50,000 personal investment larger with or without the loan from your broker?

(b) Assume that the market does unexpectedly well, for example delivering a return of 25%. Is the rate of return on your $50,000 personal investment larger with or without the loan from your broker?

(c) Assume that the market does unexpectedly poorly, for example delivering a return of -25%. Is the rate of return on your $50,000 personal investment larger with or without the loan from your broker?

(d) Summarize the general principle at work here.

5. (10 points) TLP corporation had operating cash flow of $3.20 per share last year, and has 1.5 million shares outstanding. Operating cash flows are expected to grow by 4% per year in the long run, i.e. forever. To attain this growth, TLP will need to make new capital expenditures in an amount equal to 40% of each year’s operating cash flow. TLP also has existing liabilities with a market value of $3 million.

(a) (4 points) If TLP has no other assets, and a discount rate of 13% per year is appropriate, what is the fair market value of a share of TLP stock?

(b) (6 points) Assume now that TLP has just made a breakthrough in biomedical engineering. The new project will require an immediate capital expenditure of $2.5 million, plus another $3.2 million outlay after one year. At the end of the second year the project will generate positive cash flow of $1.6 million. Subsequent cash flows from the project will grow by 4% per year in perpetuity. Given that TLP has made this breakthrough, and still assuming a 13% discount rate, what is the fair market value of a share of TLP stock?

6. (12 points, 3 points each part) The standard deviation of Asset A returns is 36%, while the standard deviation of Asset M returns is 24%. The correlation between Asset A and Asset M returns is 0.4.

(a) The average of Asset A and Asset M’s standard deviations is (36+24)/2 = 30%. Consider a portfolio, P, with 50% of funds in Asset A and 50% of funds in Asset M. Will the standard deviation of portfolio P’s returns be greater than, equal to, or less than 30%? Explain this answer intuitively.

(b) What, specifically, will be the standard deviation of portfolio P returns?

(c) Asset M is in fact the “market” portfolio. What is the Beta coefficient for Asset M? For Asset A? For Portfolio P?

(d) Assume that the CAPM holds, that the risk-free interest rate is 1% and that the expected return on the market is 7.5%. What is the expected return on Asset A? On portfolio P?

7. (12 points) Jensen Company owns a building in a suburban industrial park. It purchased the building four years ago for $3 million. It is now deciding whether to lease the building or to use it as a distribution center. It could be rented immediately. Given today’s market conditions, rental income of $120,000 per year would be expected. To convert the building to make it useful as a distribution center would require an immediate expenditure of $400,000. Having the distribution center at this location would provide Jensen with $140,000 per year in cost savings, at today’s prices. The cash flows associated with this decision are not very risky, so a real discount rate of just 3% per year is required.

For simplicity, assume that: (i) there are no taxes, (ii) the building could be rented or used as a distribution center forever, (iii) ongoing cash flows, including rents and distribution cost savings, would increase with the overall inflation rate, and (iv) all cash flows except the initial $400,000 would occur at year end. (the last assumption implies that one year of inflation would affect the first lease payment and distribution cost saving)

(a) (2 points) The inflation rate is forecast to be 4% per year. What nominal discount rate is appropriate for this project?

(b) (4 points) Provide a NPV analysis and a recommendation of how the building should be used.

(c) (2 points) Is the outcome of your NPV analysis sensitive to changes in the assumed inflation rate? (An intuitive answer without numbers is OK).

(d) (4 points) Based on the information provided, is it possible to estimate the current market value of the building? If so, provide an estimate.

8. (8 points) Ken Griffey III, a professional baseball player, is deciding between two contract offers. The Red Sox have offered Griffey an eight-year contract that would pay $12 million per year for the first two years, and $8 million per year for the remaining six years. The Yankees have also offered Griffey an eight year contract. They would pay $6.0 million per year for each of the eight years, and would also make deferred payments of $5 million per year for another eight years after the contract period finished. Assume that each payment is made at the end of the year. Griffey has determined that he will accept the contract with the highest present value. Griffey views these payments as essentially risk free, and will value them using treasury interest rates as discount rates.

(a) (3 points) Assuming that treasury interest rates are 2% per year, what is the NPV of each contract offer?

(b) (3 points) Assuming that treasury interest rates are 8% per year, what is the NPV of each contract offer?

(c) (2 points) Explain why the results in part (b) differ from part (a) in the manner that they do.