Finance Assignment

| January 22, 2015

Question 1

(10 Points) Since diversification is desired by all investors, firms should try to diversify the products and services they produce and provide.



Question 2

(10 points) The return on equity can never be greater than the return on assets of a firm.



Question 3

(15 points) Your boss has requested that you analyze two projects for him and pick the one you would recommend for investment. Both projects have the same risk because they are in the same business, and their cash flows are: Project A (Year 0: -$100,000; Year 1: $30,000; Year 2: $40,000; Year 3: $50,000; Year 4: $100,410); Project B (Year 0: -$100,000; Year 1: $0; Year 2: $10,000; Year 3: $10,000; Year 4 $225,500). Which project would you recommend?

Project B.

Either one.

Project A.

Do not have enough information to make a decision.

Question 4

(15 points) Vivian has just graduated from the University of Michigan with a BBA and must decide whether to start working now or to get an MBA. In either case, she intends to retire 20 years from today. An MBA requires an expenditure/tuition of $60,000 per year for each of the next two years, and Vivian will start working immediately after getting her MBA. Her discount rate for valuing cash flows is 7% per year. Assume that cash inflows occur at the end of the year, while the cash outflows (tuition payments) occur at the beginning of the year. If she goes to work now, she can expect a salary of $50,000 per year for each of the next 20 years. If she gets an MBA, her salary will be a constant $100,000 per year. What is the net present value (NPV) of her decision if Vivian decides to do an MBA? [Ignore taxes.]




Question 5

(15 points) You have been living in the house you bought 10 years ago for $500,000. At that time, you took out a loan for 80% of the house at a fixed rate 30-year loan at an annual stated rate of 6%. You have just paid off the 120th monthly payment. Interest rates have meanwhile dropped steadily to 5.50% per year, and you think it is finally time to refinance the remaining balance. But there is a catch. The total fee to refinance your loan is $15,000, when you include all the various costs of refinancing. Should you refinance the remaining balance for the remaining 20 years? How much would you save/lose if you decided to refinance?

(no, 13891)

(yes, 13891)

(yes, 1110)

(no, 1110)

Question 6

(15 points) XYZ’s revenues this past year were $250,000 and total costs were $150,000; and both costs and revenues have been expected to remain the same in perpetuity. XYZ is an all equity firm (i.e., it has no debt), with a return on assets of 10%, and has 100,000 shares outstanding. XYZ currently pays out all its earnings as dividends (100% payout) and has been expected to do so forever. The dividends on the basis of last year’s earnings have just been paid out. Unknown to the market, a team of researchers and the President of XYZ suddenly discover that the firm can introduce a range of new products and start expanding the market and increase earnings. However, this expansion will also increase costs and the company will be unable to pay out all the earnings as dividends. The President and her financial team have come up with two growth alternatives. (I) Grow earnings at an annual rate of 5% forever, but reduce the payout to 70% forever. No other financing will be necessary apart from this plowback (or reduction in payout). (II) Grow earnings at an annual rate of 8%, but with a reduction in payout to only 40%. Again no other financing will be necessary apart from this plowback. By how much will the price per share of the firm increase (in dollars) if it adopts the right strategy of growth? (Note that it takes time to implement any growth strategies. So the reinvestment starts at year end, or t = 1.) (Enter just the number without the $ sign or a comma.)

Answer for Question 6

Question 7

(20 points) MyWorld, Inc. is an all-equity firm whose current business involves manufacturing and selling software. The company is blessed in that it operates in capital markets that are perfect, that is, there are no taxes or bankruptcy costs. The current weighted average cost of capital (WACC) of MyWorld, Inc. is 8.50%, and its equity beta is 0.90. MyWorld, Inc. is considering penetrating the wine industry, and would like its total value to consist of 70% software and 30% wine. The wine project requires a $800,000 investment at t = 0 and will yield $150,000 a year for the following 40 years, starting a year from today (at t = 1). The manager of the new project has found that the average return on equity is 20%, and the average debt-to-equity ratio is 1.00, in the wine industry. All the debt in this industry is viewed as default free by the market. The risk free rate is 4%, the market risk premium (the average difference between the return on the market and the risk-free rate) is 5%, and the wine project will be financed with $600,000 of debt. What is the NPV of this project?(Enter just the number without the $ sign or a comma.)

Answer for Question 7


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