FINANCE 634

Fall 1998 Exam 2

Part 1



1. Suppose a government bond is listed today in the Wall Street Journal as shown below:

Rate= 10.25
Type=Nov14
Bid=103:05
Ask=103:25

The next coupon payment is due in exactly 6 months. The bond pays semiannual interest and matures on November 15th of its terminal year. (Today is November 15th, 1998)

Compute the Yield to Maturity on the bond.

[5] Answer: _________________


2. Suppose you purchase a bond today for a speculative investment with the plan to hold it for three years and then sell it. The bond has a coupon rate of 8.5% with semiannual payments and 14 years to maturity. (The next interest payment is due in exactly six months.) The bond is quoted in Barron's with a Current Yield (Cur Yld) of 9.5%. You are willing to bet that interest rates will change during the next three years to the extent that you will make at least 12% as an average annual holding period return on this bond. For this to turn out to be true (that is, for your holding period return to be at least 12%), what is the maximum yield to maturity that can exist for this bond in three years when you intend to sell it?

[5] Answer:______________


B. What could account for this change in the yield for this bond? List ALL of the factors that could account for this change.[3]

 

3. Suppose you are considering whether or not to purchase shares of stock for the ABD Corporation. You expect the next annual dividend to be $3.50 per share, and you expect that it will be a full year before the next dividend is paid. The required return is 12% and the expected constant annual growth rate is 6%. What should be the market price for this stock?

[5] Answer: ________________


4. Suppose you are considering whether or not to purchase shares of stock for the ABD Corporation. You expect the next annual dividend to be $3.50 per share, and you expect that it will be three months before the next dividend is paid. You also expect that the company will maintain a 60% payout ratio and will be able to earn 15% return on equity on average per year throughout the foreseeable future. ABD has a of 1.15, the yield on Treasury Bills is 6.5%, and the expected average annual return on a market index is 12.5%. What should be the market price for this stock?

[5] Answer: _________________

 

5. The ABD Co. is considering expanding its production of one product by replacing an existing production line with a newer and more efficient one. The existing equipment was purchased three years ago for $1,200,000 and is being depreciated using the straight-line method over 4 years (one year remaining) to a zero book value at the end of the fourth depreciation year. This equipment has a current market value of $450,000. If this equipment is used for three more years, it is expected to have a market value of $50,000 at the end of that time.

The proposed new equipment has an installed cost of $850,000 and will be depreciated by 3-year ACRS-class rules using these percentages (.3334 in the first year, .4444 in the second year, .1481 in the third year) over the THREE years that the line will be used. If this equipment is used for three more years, it is expected to have a market value of $150,000 at the end of that time. Delivery, installation, and setup costs for the new equipment will total $40,000 in one-time costs.

If the decision is made to replace the current equipment, it is estimated that annual cash revenue will increase by $300,000 and that annual cash operating expenses will increase by $60,000. Both production lines require a net working capital investment over the life of the equipment equal to 5% of the original purchase price of the equipment.

The company's marginal tax rate is 28%. The appropriate discount rate is 12.0%. Answer the following questions. Show all relevant work in the space provided here. LABEL EVERYTHING CLEARLY.

a. Net Cash Outlay at t=0: $_______________ [5]

b. Net Cash Flow at t=1: $_________________ [10 Total]

Net Cash Flow at t=2: $_________________

Net Cash Flow at t=3: $_________________

 

Based on your answers above, determine:

c. Expected Net Present Value: $________________ [3]

d. Internal Rate of Return (within 1.0%): _________________ [3]

e. Modified Internal Rate of Return: _________________ [3]

f. Equivalent Annual Annuity: _______________________ [3]


EXTRA CREDIT: NO PARTIAL CREDIT

g. Suppose neither set of equipment is worth anything at the end of three years due to technological obsolecence. How does this affect the expected NPV of the project?

[3] Answer: _____________________


h. What is the minimum change in expected revenue needed to give the project a positive expected NPV? (Ignore the change in Part g.)

[3] Answer: ______________________


Answers:

1. 9.78%

2. 8.89%

2b. Expected inflation rate decreased, risk of the borrower decreased, real rate of interest decreased, or general risk aversion decreased.

3. $58.33

4. $51.97

5. CF(0)=-$453,300; CF(1)=$168,149; CF(2)=$278,567; CF(3)=$280,184

c. NPV=$118,334

d. IRR=25.40%

e. MIRR=21.00%

f. EAA=$49,268

g. Best answer: It doesn't. "Expected" is ex ante - what actually happens is ex post. Expectation cannot incorporate what is known when the expectation is derived.

h. A drop of about $68,000 per year is the most that will leave the project with a positive NPV.