PART A
1) A firm is considering two mutually exclusive investments, each with an initial outlay of $100,000 and an expected life 3 years. Assume that the firm has of capital of 10 percent for each project. The two investments are of equal risk and have the following cash flows:
Investment A Investment B
Year 0 -$100,000 -$100,000 Year 1 $40,000 $55,000 Year 2 $50,000 $55,000 year 3 110,000 55,000
Calculate the payback period and the net present value for each investment. SHOW YOUR CALCULATIONS
Based on the NPV and payback period calculations, which investment should the firm choose? Why?
NPV - Investment AYear / Cash Flow / PV Factor @ 10% / PV
0 / ($100,000) / 1 / ($100,000)
1 / $40,000 / 0.9091 / $36,364
2 / $50,000 / 0.8264 / $41,322
3 / $110,000 / 0.7513 / $82,645
NPV / $60,330.58
Payback Period - Investment A
Year / Beginning Unrecovered Investment / Cash Flow / Ending Unrecovered Investment
0 / $100,000 / $0 / $100,000
1 / $100,000 / $40,000 / $60,000
2 / $60,000 / $50,000 / $10,000
3 / $10,000 / $110,000 / ($100,000)
Since only $10,000 need to be recovered in Year 3 while the cash inflow is $110,000, the investment would be recovered in a fraction of Year 3. To calculate this fraction we divide $10,000 by $110,00 = 0.091. The payback period = 2.091 years
NPV - Investment BYear / Cash Flow / PV Factor @ 10% / PV
0 / ($100,000) / 1 / ($100,000)
1 / $55,000 / 0.9091 / $50,000
2 / $55,000 / 0.8264 / $45,455
3 / $55,000 / 0.7513 / $41,322
NPV / $36,776.86
Since only $45,000 need to be recovered in Year 2 while the cash inflow is $55,000, the investment would be recovered in a fraction of Year 2. To calculate this fraction we divide $45,000 by $55,000 = 0.82. The payback period = 1.82 years
Based on NPV, investment A should be accepted since it has a higher net present value, while investment B would be accepted based on the payback period since it has a shorter payback period.
NPV calculations are more accurate though since they take the time value of money into consideration; this is in addition to the fact that the payback period technique does not consider cash flows beyond the payback period. Accordingly, the firm should accept investment A.
2) What is the basic relationship between interest rates and bond prices, and why does this relationship exist?
The relationship between interest rates and bond prices is an inverse relationship; When interest rates increase, bond prices decrease, and when the interest rates decrease, bond prices increase.
3) Why is preferred stock considered to be a hybridsecurity? Explain.
This is because preferred stock combines features of debt and equity. They are like debt in the sense that it pays a fixed dividend – which is similar to coupon payments paid on bonds; they are like equity in the sense that a firm is not obliged to make annual dividend payments.
PART B:
1)An investor expects the value of a $1,000 investment to double within 8 years. What is the expected annual rate growth in the investment?
Using the Rule of 72,
Therefore i =
= 9%
Using excel:
PV / ($1,000)FV / $2,000
Number of Periods / 8
Interest Rate / 9.05%
2) A firm has a total debt of $600,000 and equity of $400,000. What is the debt/net worth ratio and the debt-to-total assetratio for the firm? SHOW YOUR CALCULATIONS
Debt / Net Worth Ratio = Total Debt / Total Equity
= $600,000 / $400,000
= 1.5
Total Assets = Total Debt + Total Equity
= $600,000 + $400,000
= $1,000,000
Debt-to- Total Assets Ratio = Total Debt / Total Assets
= $600,000 / $1,000,000
= 0.6
3)In brief, what happens to the value of money if prices in general fall?
When prices fall, the value of money increase, this is because you can buy more quantity of goods for a lower amount of money.
4)What is the future value of a $10,000 investment after 18 years, if the annual rate of interest is 8 percent? SHOW CALCULATIONS
FV = PV × (1+r)t
FV = $10,000 × (1.08)18
= $39,960.20
5)A bound has a principal amount of $1,000, an annual interest payment of $100, and a maturity of 10 years. What is the bond's value or price, if comparable debt yields 12 percent?
=
= $886.996
Approx. $887
6) A firm has preferred stock outstanding that has a $40 annual dividend, a $1,000 par value, and no maturity. If comparable yields are 9 percent, what should be the price of the preferred stock?
= $444.44
6)Your broker recommends that you purchase Good Mills stock at $30. The stock pays a $2.20 annual dividend that’s expected to grow annually at 8 percent. ( The same rate of growth is expected for its per-share earnings.) If you want to earn 15 percent on your funds, should you purchase this stock ? SHOW YOUR CALCULATIONS
D1 = $2.20 × 1.08
= $2.376
=
= 15.92%
Since the stock rate of return is higher than the required rate of return, then I should purchase the stock.
7)Identify three advantages of establishing a corporation instead of a sole proprietorship.
The advantages of a corporation are:
1)Limited Liability: in a corporation, owners’ liability is limited to the amount invested in the corporation, while in a sole proprietorship, the owner has an unlimited liability.
2)Unlimited Life: a corporation is regarded as a separate legal entity that has unlimited life, while a sole proprietorship’s life is limited to the life of its owner.
3)Ease of Raising Capital: raising capital for a corporation is easier since it can be raised by offering shares of stock in the market.
8)What are the main functions of the break- even analysis?
Breakeven analysis is a technique used to determine that level of output at which total expenses equals total revenues. It is used by management to determine the effects of 1) fluctuation in sales, 2) fluctuations in cost, and 3) changes in fixed costs relative to variable costs on the levels of profit.
9)Jennifer wants to buy a new car four years from now that will cost $15,000. In order to meet this goal, how much money must she save annually, if the funds earn an interest rate of 6 percent?
The $15,000 represents the Future Value of the amount Mary needs to save annually.
The annual savings would represent an annuity
The FV of annuity is calculated as follows:
C =
= $3,428.87