March 13, 2019
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March 13, 2019

Time Value of Money: Review the examples of Time Value of Money (TVM) problems in Chapter 5 of the text. (Fundamentals of Financial Management, 13th Edition)

1. Time Value of Money: Review the examples of Time Value of Money (TVM) problems in Chapter 5 of the text. (Fundamentals of Financial Management, 13th Edition)
• Using your own industry as the context, create and solve four of your own original TVM problems: (1) lump-sum present value, (2) lump-sum future value, (3) present value of an annuity, and (4) future value of an annuity. Your scenarios may be fictitious, but they should make sense in the real-life context of your industry.
• Write a 1-paragraph summary for each of your scenarios that explains the “real-life” context of these four problems as well your interpretations of each of the calculations. (4 paragraphs total)

2. BOND VALUATION An investor has two bonds in her portfolio, Bond C and Bond Z. Each bond matures in 4 years, has a face value of $1,000, and has a yield to maturity of 9.6%. Bond C pays a 10% annual coupon, while Bond Z is a zero coupon bond.
• a.Assuming that the yield to maturity of each bond remains at 9.6% over the next 4 years, calculate the price of the bonds at each of the following years to maturity:
Years to Maturity Price of Bond C Price of Bond Z
4 ______ ______
3 ______ ______
2 ______ ______
1 ______ ______
0 ______ ______
• b.Plot the time path of prices for each bond.

3. Yield-to-Maturity and Yield-to-Call
1. Kaufman Enterprises has bonds outstanding with a $1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is $1,175. The bonds may be called in 5 years at 109% of face value (Call price = $1,090).
• a.What is the yield to maturity?
• b.What is the yield to call if they are called in 5 years?
• c.Which yield might investors expect to earn on these bonds? Why?
• d.The bond’s indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be called at 109% of face value; but in each of the next 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in Year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?

4. CAPM AND REQUIRED RETURN Bradford Manufacturing Company has a beta of 1.45, while Farley Industries has a beta of 0.85. The required return on an index fund that holds the entire stock market is 12.0%. The risk-free rate of interest is 5%. By how much does Bradford’s required return exceed Farley’s required return?

5. CAPM AND REQUIRED RETURN Calculate the required rate of return for Manning Enterprises assuming that investors expect a 3.5% rate of inflation in the future. The real risk-free rate is 2.5%, and the market risk premium is 6.5%. Manning has a beta of 1.7, and its realized rate of return has averaged 13.5% over the past 5 years.

6. CONSTANT GROWTH VALUATION Thomas Brothers is expected to pay a $0.50 per share dividend at the end of the year (that is, D1 = $0.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock, rs, is 15%. What is the stock’s current value per share?

7. NONCONSTANT GROWTH VALUATION Hart Enterprises recently paid a dividend, D0, of $1.25. It expects to have nonconstant growth of 20% for 2 years followed by a constant rate of 5% thereafter. The firm’s required return is 10%.
a.How far away is the horizon date?
b.What is the firm’s horizon, or continuing, value?
c.What is the firm’s intrinsic value today, ˆP0?

8. COST OF COMMON EQUITY AND WACC Patton Paints Corporation has a target capital structure of 40% debt and 60% common equity, with no preferred stock. Its before-tax cost of debt is 12%, and its marginal tax rate is 40%. The current stock price is P0 = $22.50. The last dividend was D0 = $2.00, and it is expected to grow at a 7% constant rate. What is its cost of common equity and its WACC?

9. Imagine you are the manager of operations for a manufacturing company. Your vice president wants to expand production by building a new facility, and she would like you to develop a business case for the project. Assume that your company’s weighted average cost of capital is 13%, the after-tax cost of debt is 7%, preferred stock is 10.5%, and common equity is 15%. As you work on the business case, you surmise that this is a fairly risky project because of a recent slowing in product sales. In fact, when using the 13% weighted average cost of capital, you discover that the project is estimated to return about 10%, which is quite a bit less than the company’s weighted average cost of capital. Your vice president suggests that the project could be financed from a mix of retained earnings (50%) and bonds (50%). She reasons that retained earnings do not cost the company anything because it is cash you already have and the after-tax cost of debt is only 7%. That would lower your weighted average cost of capital to 3.5% and make your 10% projected return look great.

Is your vice president’s suggestion to use a mix of 50% retained earnings and 50% bonds a good approach for this expansion? Explain why or why not. (1 paragraph)

10. CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows, including depreciation, are as follows:

• a.Calculate NPV, IRR, MIRR, payback, and discounted payback for each project.
• b.Assuming the projects are independent, which one(s) would you recommend?
• c.If the projects are mutually exclusive, which would you recommend?
• d.Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?
• Which calculation would you recommend in your evaluation—NPV or IRR? Why? (1 paragraph)

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