# investment evaluation assignment

Queation1

Intel Corporation is a leading manufacturer of semiconductor chips. The firm was incorporated in 1968 in Santa Clara, CA and represents one of the greatest success stories of the computer age.

Although Intel continues to grow, the industry in which it operates has matured so there is some question whether the firm should be evaluated as a high- growth company or stable-growth company from now on. For example, in December of 2007 the firm’s shares were trading for $20.88, and have a price-earnings ratio of 17.622. Compared to Google Corporation’s price-earnings ratio of 53.71 on the same date it would appear that the decision has already been made by the market.

Intel’s expected earnings for 2007 are $1.13 per share and its payout ratio is 48%. Furthermore, selected financial data for the sector, industry, and seven of the largest firms (including Intel) is found in the attachment…

a. Is Intel’s current stock price of $20.88 reasonable in light of its sector, industry, and comparison firms?

b. Intel has a beta coefficient equal to 1.66. If we assume a risk free rate of 5.02% and a market risk premium of 5%, what is your estimate of the required rate of return for Intel’s stock using the CAPM? What rate of growth in earnings is consistent with Intel’s policy of paying out 48% of earnings in dividends and the firm’s historical return on equity? Using your estimated growth rate, what is the value of Intel’s shares using the Gordon n (single-stage) growth model? Analyze the reasonableness of your estimated value per share using the Gordon model.

c. Using your analysis in part b above, what growth rate is consistent with Intel’s current share price of $20.88?

d. Analysts expect Intel’s earnings to grow at a rate of 12% per year over the next five years. What rate of growth from year 6 forward (forever) is needed to warrant Intel’s current stock price (use your CAPM estimate of the required rate of return on equity)? (Hint: use a two stage growth model where Intel’s earnings grow for 5 years at 12% and from year 6 forward at a constant rate.)

Question 2

Morrison Oil and Gas is faced with an interesting investment opportunity. The investment involves the exploration for a significant deposit of natural gas in southeastern Louisiana near Cameron. The area has long been known for its oil and gas production, and the new opportunity involves developing and producing 50 million cubic feet (MCF) of gas. Natural gas is currently trading around $14.03 per MCF; the next year, when the gas would be produced and sold, could be as high as $18.16 or as low as $12.17. Furthermore, the forward price of gas one year hence is currently $14.87. If Morrision acquires the property, it will face a cost of $4.00 per MCF to develop the gas.

The company truing to sell the gas field has a note of $450 million on the property that requires repayment in one year plus 10% interest. If Morrison buys the property, it will have to assume this note and responsibility for repaying it. However, the note is nonresourse; if the owner of the property decides not to develop the property in on year, the owner can simply transfer ownership of the property to the lender.

The property’s current owner is a major oil company that is in the process of fighting off an attempted takeover; thus it needs cash. The asking price for the equity in the property is $50 million. The problem faced by Morrison’s analysts is whether the equity is worth this amount. (Answer the following assuming zero taxes)

a) One possible response to the valuation question is to estimate the value of the project where the price risk of natural gas is eliminated through hedging. Estimate the value of the equity in the project where all the gas is sold forward at the $14.87-per-MCF price. The risk-free rate of interest is currently 6%.

b) Alternatively, Morrison could choose to wait a year to decide on developing it. By delaying, the firm chooses whether or not to develop the property based on the price per MCF at year-end. Analyze the value of the equity of the property under this scenario.

c) The equity in the property is essentially a call option on 50 MCF of natural gas. Under the conditions stated in the problem, what is the value of a one-year call option on natural gas with an exercise price of 13.90 MCF worth today? (Hint: use the binomial option pricing model).

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