FINA 307 Survey Of Finance Summer 2017 Assignment 3 And 4 Du

Fina 307 Survey Of Financesummer 2017 Assignment 3 And 4 Due At T

Fina 307 Survey of Finance Summer 2017 Assignment 3 and 4 (due at the beginning of class on Thursday, June 29th): Remember: you are expected to show all work including timelines, formulas, inputs, and outputs.

1. Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 10 percent, and that the maximum allowable payback for the project is 2.5 years. a. Use the IRR to evaluate this project; should it be accepted or rejected? b. Use the NPV decision rule to evaluate this project; should it be accepted or rejected? c. Use the PB to evaluate this project; should it be accepted or rejected?

2. At the beginning of the year you owned $3,000 of Dollenz stock, $11,000 of Torkelson stock, and $6,000 of Nesmith stock. During the year the three companies' returns were -7.6 percent, 21.4 percent, and 14.8 percent respectively. What is your portfolio return?

3. Using the following returns, calculate the average return, the variance, the standard deviation, and the coefficient of variation for Jones stock. Year Jones 1 7% 2 14% 3 -3% 4

4. You own $2,500 of Diner's Corp stock that has a beta of 2.6. You also own $2,500 of Comm Corp (beta = 1.1) and $5,000 of Airlines Corp (beta = 0.3). Assume that the market return will be 10 percent and the risk-free rate is 4 percent. What is the risk premium of the portfolio?

5. A manager believes his firm will earn a 16 percent return next year. His firm has a beta of 1.5, the expected return on the market is 14 percent, and the risk-free rate is 4 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued.

6. The balance sheet for Stratton Co. shows $400,000 in common equity, $100,000 in preferred stock, and $500,000 in long-term debt. The company has 20,000 common shares outstanding at a market price of $65 per share. The firm’s 4,000 shares of preferred stock are currently priced at $50 per share. The firm has 500 bonds outstanding selling at par value ($1,000). The company’s before-tax cost of debt is 6%. The cost of common stock and preferred stock are estimated to be 10% and 7% respectively. If the firm’s marginal tax rate is 40%, what is the firm’s weighted average cost of capital (WACC)?

Paper For Above instruction

The financial decision-making process involves critical evaluation tools that guide firms in determining the viability of investments, managing portfolios, and structuring optimal capital frameworks. This paper explores key financial analyses, including investment appraisal methods, portfolio return calculations, risk measurement, and the Weighted Average Cost of Capital (WACC), supported by relevant financial theories and practical calculations.

Investment Appraisal Methods

When assessing a potential investment, firms often rely on the Internal Rate of Return (IRR), Net Present Value (NPV), and Payback Period (PB). Each approach offers unique insights into project viability. The IRR is the discount rate at which the project's cash flows equate to zero, reflecting the project's rate of return. If the IRR exceeds the required rate of return (here, 10%), the project is considered attractive. For the given project, calculating the IRR involves setting the net cash flows to zero and solving iteratively or using financial calculator functions. If the IRR exceeds 10%, the project should be accepted; otherwise, rejected.

The NPV measure discounts all future cash flows to their present value using the required rate of return. A positive NPV indicates value addition; thus, the project is acceptable. Conversely, a negative NPV suggests the project would destroy value. Using the NPV formula, summing discounted cash flows minus initial investment provides the decision criterion.

The Payback Period calculates how long it takes to recoup initial investments. A shorter PB relative to the maximum acceptable period (2.5 years) signifies a better investment opportunity. If the PB is less than or equal to 2.5 years, accept; else, reject.

Portfolio Return Calculation

The total portfolio return considers the initial investment in each stock and their individual returns. The portfolio value at the start includes $3,000 in Dollenz, $11,000 in Torkelson, and $6,000 in Nesmith stocks, totaling $20,000. The returns are weighted by their proportion in the total portfolio:

Portfolio Return = (Weight of Dollenz Return of Dollenz) + (Weight of Torkelson Return of Torkelson) + (Weight of Nesmith * Return of Nesmith)

Calculating weights: Dollenz = 3,000/20,000 = 0.15; Torkelson = 11,000/20,000 = 0.55; Nesmith = 6,000/20,000 = 0.30.

Total Return = (0.15 -7.6%) + (0.55 21.4%) + (0.30 * 14.8%) = -1.14% + 11.77% + 4.44% = 14.07%

Statistics for Jones Stock

The mean return (average) over the four years is calculated as:

Average Return = (7% + 14% + (-3%))/3 = 6%

Variance measures the dispersion of returns around the mean, calculated as the average squared deviation. The standard deviation is the square root of variance, indicating the risk or volatility. The coefficient of variation (CV) relates the standard deviation to the mean, providing a risk-to-return ratio.

Portfolio Risk Premium

The risk premium of a portfolio reflects the excess return over the risk-free rate, given its beta weightings and market risk. It is computed as:

Expected Portfolio Return = Σ (Weight_i * Expected Return_i)

Given the market return (10%) and risk-free rate (4%), for each stock:

- Diner's Corp: Beta = 2.6, Risk Premium = (Market Return - Risk-Free Rate) Beta = (10% - 4%) 2.6 = 6% * 2.6 = 15.6%

- Comm Corp: Beta = 1.1, Risk Premium = 6%

- Airlines Corp: Beta = 0.3, Risk Premium = 6%

Weighted risk premium = (2500/7000 15.6%) + (2500/7000 6%) + (5000/7000 * 1.8%) ≈ 5.54% + 2.14% + 1.54% ≈ 9.22%

Valuation and Performance Analysis

The Capital Asset Pricing Model (CAPM) states that the expected return of a security is:

E(R) = Rf + β * (Rm - Rf)

where Rf is the risk-free rate, Rm is the market return, and β is the security’s beta. For a firm with beta 1.5, expected return:

E(R) = 4% + 1.5 (14% - 4%) = 4% + 1.5 10% = 4% + 15% = 19%

Since the manager estimates a 16% return while the CAPM suggests a 19% return, this indicates the firm might be undervalued if priced at the lesser expected return, or over-valued if market expectations are higher.

Weighted Average Cost of Capital (WACC)

WACC incorporates the costs of equity and debt, weighted by their proportions in the capital structure. The formula:

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

Calculations:

- Equity (E) = $400,000 (common) + $100,000 (preferred) = $500,000

- Market value of equity = 20,000 shares * $65 = $1,300,000

- Market value of preferred stock = 4,000 shares * $50 = $200,000

- Debt (D) = $500,000 bonds at par

- Total Value (V) = Equity + Preferred + Debt = $1,300,000 + $200,000 + $500,000 = $2,000,000

- Equity weight = $1,300,000 / $2,000,000 = 0.65

- Preferred stock weight = $200,000 / $2,000,000 = 0.10

- Debt weight = $500,000 / $2,000,000 = 0.25

Using the costs:

- Re (cost of equity) = 10%

- Rp (cost of preferred) = 7%

- Rd (cost of debt) = 6%

- Tc (tax rate) = 40%

WACC = (0.65 10%) + (0.10 7%) + (0.25 6% (1 - 0.40))

WACC = 6.5% + 0.7% + 0.9% = 8.1%

Therefore, the firm's WACC is approximately 8.1%, reflecting the average required return on the company's financing sources considering tax advantages.

Conclusion

Financial analysis processes such as IRR, NPV, payback period, portfolio return calculations, risk measurement, and WACC computation form the backbone of effective corporate finance decision-making. These tools allow firms to evaluate investment opportunities, manage risk, and optimize their capital structures, ultimately supporting sustainable growth and value maximization.

References

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