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Exam #3

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1. (25pts) Calculate the net present value (NPV) and internal rate of return (IRR) for Projects A and B. Assume a discount rate of 5%. Should the firm accept or reject these projects? If Project A and Project B are mutually exclusive, which is the better choice? Explain. What are “non-conventional” cash flows? What issues arise when evaluating projects with “non-conventional” cash flows and how can you address these issues?

NPV for Project A using a 5% discount rate

NPV = -10,000 + (60,000/(1+.05)) + (0/(1+.05)) + (60,000/(1+.05))

= -10,000 + 57,142.8571 + 0 + 57,142.8571

= 104,285.7142

NPV for Project B using a 5% discount rate

NPV = -1 + (0/(1+.05)) + (0/(1+.05)) + (100/(1+.05))

= -1 + 0 + 0 + 95.2381

= 94.2381

In a situation where Projects A and B are mutually exclusive, an investment in Project A would be much more effective and beneficial that Project B. The NPV value of Project A is much higher indicating that the investor is bound to generate a high return. The non-conventional cash flows are attributed to the value of investment for each project. In this case, the higher the value, the higher the profits. Therefore, the greater the risk on the investment of the projects that greater the benefits.

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2. (20pts) Based on the following information, calculate the geometric average return, arithmetic average return, variance, and standard deviation for the stock. Draw and label a graph of a normal distribution using the mean and standard deviation. Compare and contrast the geometric and arithmetic average returns.

Table 1

Table 1 calculates the geometric average return which shows a #Null value, arithmetic average return #120%, variance #2.650714, and standard deviation for the stock #1.628101.

The graph compares the mean and the standard deviation of the variables presented. This shows that the investment has a higher standard deviation than the average mean. Furthermore, the geometric mean has a null value indicating that the negative figures complicate the rate of return of the investment. The arithmetic average return shows a positive value which indicates that while the investment remains unproductive it is resilient.

3. (20pts) Stock Z has a beta of 2, Treasury Bills currently return 0.1%, and the average return on the S&P 500 for the last 20 years has been 6%. What is the expected return for Stock Z? Graph the security market line and Stock Z. Label all relevant details. What does beta (β) represent?

Stock Z Beta = 2

Treasury Bills return = 0.1%

Avg. Return of S&P 500 last 20 years = 6%

Expected Return for Stock Z?

= (0.1 + 6) * 2

= 12.2%

The beta (β) presents the rate of competitiveness of the stock in the 20-year period. This is critical to emphasize the rate of return in which the stock is bound to generate over the years.

4. (20pts) Stock Z (from #3) pays no dividends and is currently trading at $700. Stock Z is forecasted to have a stock price of $640 in 1 year. What is the forecasted rate of return for Stock Z? Based on your response in #3, is Stock Z underpriced, overpriced, or correctly priced? Justify your reasoning mathematically. Assuming all these assumptions are correct, how would an efficient market react to this situation?

Stock Z = #3 above

Currently Trading at $700

Forecasted Stock Price in 1 year = $640

Forecasted rate of return = ((700-640) / 700) * 100

= 8.5714 %

The forecasted rate of return for the stock has a depreciation value of 8.5714%.

The stock is currently underpriced since it is bound to depreciate in value over the next one year. This shows that there is no profit generated rather the stock is bound to incur some losses. Therefore, the stock’s investment induces an adverse effect.

5. (15pts) Planet Express has $400 in equity and $600 in assets. The average YTM on its debt is 8% and the tax rate is 21%. The company has announced $1 annual dividends in perpetuity and has a stock price of $10. What is the company’s weighted average cost of capital (WACC)? Why is the tax rate included in the WACC? Describe how the WACC is used to evaluate potential investments.

Planet Express

Equity = $400

Assets = $600

Avg. YTM on debt = 8%

Tax rate = 21%

Annual dividends in perpetuity = $1

Stock price = $10

Weighted Average Cost of Capital (WACC) =??

WACC = (E/V * Re) + (D/V * Rd * (1-Tc))

Where: –

E = Market value of the firm’s equity

D = Market value of the firm’s debt

V = E + D

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate Tax

WACC = (600/648 * 400) + (48/648 * 48 * (1-.21))

= 370.3704 + 2.8089

= $373.1793