Part A: Answer each of the following questions in one to three sentences, and perform calculations as requested.
1. The following table summarizes a portion of U.S. federal corporate tax rates for the 2007 tax year. Explain whether corporate tax rates are progressive, regressive, of flat. Use a very simple example from the table to make your position and explanation clear.
Taxable Income More than Taxable Income Less than Tax Rate
$0 $50,000 15%
$50,001 $75,000 25%
$75,001 $100,000 34%
It is obviously a progressive tax rate. The tax rate is increasing as the income is increasing, therefore the total tax payable increases with the increase in income. For example, if a person earns 50000, the tax to be paid is $7500 and when the income is $60000, the tax on next 10000 will be at the rate of 25% which is equal to $2500, therefore the total tax on $60000 will be 7500+2500 = 10000, the average tax rate will be 10000/60000 = 16.67% which is higher than 15%.
2. Recall that the net present value (NPV) and internal rate or return (IRR) techniques take the time value of money into consideration. Compare and contrast these two techniques, focusing on IRR when the NPV is positive, zero and negative. Be sure to include a discussion of NPV discount rate in your response.
If NPV is negative, it is sure that the IRR would be less than cost of capital and the cost of capital would be more than 10%. NPV is calculated by discounting the future cash inflows to determine the present value, then this present value is deducted from cash outflow, to arrive at NPV, if the present value of inflows is more than outflows, it is called positive otherwise negative. If the NPV is positive, its IRR would be more than the rate at which the future cash inflows have been discounted, and at negative NPV the IRR would be lower than the discounted rate. If the NPV is said to be zero, it means that the IRR and the discount rate is the same.
The NPV is used where the projects are mutually exclusive and if they are not mutually exclusive the NPV index is used to determine which project should be preferred. In the current case as there is only one project therefore the decision should be taken on the basis of NPV or IRR, it will not make any difference. If the NPV is negative the project should be rejected and definitely the IRR would also be lower than the discount rate of 10%. In any case the project should not be accepted.
3. Recall that the security market line (SML) illustrates the relationship between systematic risk and expected returns. Perhaps the most famous and practical application of the SML is the capital asset pricing model (CAPM), as follows:
E(R1) = RF + [E(RM) – RF] X βi
a. Define each of the variables or terms in this equation.
E(R1) = Expected or required rate of return on investment or equity.
RF = Risk free rate of return which is normally of government securities like U.S. Treasury Bond rate.
[E(RM) = Expected market rate of return, the return on assets or equity of the market to which it belongs, if an asset is listed on stock exchange the average rate of return of exchange will be the market rate of return.
E(RM)– RF] = Market risk premium, the difference between market rate of return and risk free rate of return.
Βi= Beta of the selected assets or equity.
b. Calculate the E(Ri), assuming that E(RM) equals 12% Rf equals 6% and βi equals 1.2.
6+12-6*1.2 = 13.2%
4. Describe the differences between an ordinary annuity, an annuity due, and perpetuity.
The annuity is the same series of payment to be received or paid over a period of time, if it is to be paid or received at the beginning of the period, it is called annuity due and if it is at the end of the period it is called annuity ordinary and it is to be paid or received forever, it is called in perpetuity.
5. Assume that a project has a negative net present value (NPV) of $500 and an internal rate or return (IRR) of 10%. Is the discount rate used to calculate the NPV higher than, lower than, or equal to 10%? Compare and contrast these two techniques, using this example, and focusing on IRR when the NPV is positive, zero and negative.
If the IRR is 10% it means that the NPV would be zero at this point and the negative NPV would be when the cash flow would have been discounted for more than 10%. Now suppose that the investment of $1000 was made only for one year and the 1100 is received after one year and if it is discounted at 10%, the present value will be $1000 and if it is discounted with 120^ rate the value of $1100 will be $500 which will give a negative NPV of $500 and if $1100 is discounted with 8%, the present value will be $1019, which will give positive NPV of $19.
Part B: Answer each of the following questions in a composition of 1-2 paragraphs, or perform calculations as requested. Each answer is worth 20 points.
6. Explain the concept of venture capital. Include a definition of the term venture capital, describe who will need to obtain venture capital financing, and explain the type of return that’s required from a venture capital firm.
It is a source of financing which is provided by investor to small and start up business with a hope of potential growth in business In future. As it is very difficult for new business to obtain loan or financing from banks and other financial institutions therefore this source of financing is provided to help new businesses. As the risk involve in this source of financing is on higher side therefore the rate of return or the interest rate asked by the money provider is also on higher side.
7. In a typical loan amortization, the principal component of a fixed payment increases and the interest component decreases with each payment. The following figure illustrates this relation for a hypothetical 30-year mortgage.
Interest
Component
Of payment
Principal
Component
Of payment
Assume that someone borrows $5,000 at an interest rate of 9 percent per year for five years, and agrees to make interest and principal payments in the amount of $1,285.46 at the end of each year. Prepare a loan amortization schedule for each of the five years, showing the beginning principal balance, the total payment of $1,285.46, the interest component of the payment, the principal component of the payment, and the ending principal balance. Fill in the blank spaces in the following framework to complete your answer:
LOAN AMORTIZATION SCHEDULE
1 / 5000 / 1285.46 / 450 / 835.46 / 4164.54
2 / 4164.54 / 1285.46 / 374.81 / 910.65 / 3253.89
3 / 3253.8886 / 1285.46 / 292.85 / 992.61 / 2261.28
4 / 2261.2786 / 1285.46 / 203.52 / 1081.94 / 1179.33
5 / 1179.3336 / 1285.46 / 106.13 / 1179.33 / 0.0
6427.3 / 1427.30 / 5000.00
8. The weighted average cost of capital (WACC) can be related to the basic accounting equation, as follows:
A = L + OE
Compare and contrast the WACC to this basic accounting equation. Does the WACC contain a profit component? How does the WACC relate to the discount rate used in a net present value (NPV) computation, using a case where NPV equals zero to make your point?
In this equation the A represents total assets and they are financed by L + OE, where L is the total liabilities and the OE is the owners’ equity. The L + OE describe the capital structure of the financing used to purchase the total assets. Both source of financing do have cost, the liabilities do have the cost in the form of interest while the OE has the cost in the form of required rate of return by the owner. The OE also includes the profit earned by the business but not distributed as dividend or withdrawn by the owner of the business. The cost of liabilities is normally lower than the cost of OE as it has tax shield on interest expenses. For example, the interest rate is 10% and the required rate of return is also 10%, and the company pays 30% tax on its income, then the cost of debt will be 10*1-.3 = 7% and the cost of OE will be 10%, if total assets have been financed equally by these two sources then the weighted average cost of capital will be 7+10/2 = 8.5%. Now the company has to use this 8.5% to discount all its future cash flow for project investment decision making purpose. If company makes investment of 1000 today and can earn $1085 after one year, then the present value at 8.5% of this 1085 will be equal to $1000, which will give a zero NPV, it means that the company cannot make investment below this rate of 8.5% which is its WACC.