Reference no: EM13720903

Question 1:

You have recently received a relatively large insurance settlement and have been referred to a financial analyst for investment advice. The financial analyst has advised you that you should consider splitting your investment funds between one-year Government of Canada treasury bills, the bonds of Alpha Ltd., and the common shares of Delta Company in order to achieve a reasonable degree of diversification. The analyst has also advised you that before making any final decision, you should also consider your tax situation because the different investments will require different tax treatments.

As a first step in your decision process, you have decided to determine the after-tax return that you might expect to receive from each of these three different types of investments. You know that based on your circumstances, your marginal federal tax rate is 29% and your marginal provincial tax rate is 16%. You also know that the gross up on eligible dividends is 38%, the dividend tax credit is 15.02% of the grossed-up amount, and the provincial tax rate on eligible dividends is 10.8% of the actual dividend.

Required

a. The bonds of Alpha Ltd. carry a coupon rate of 4% paid semi-annually and have seven years remaining until maturity. The financial analyst has informed you that based on anticipated changes in interest rates, the bonds will be priced to yield 4.4% in one year's time. Based on the analyst's advice, you have decided to purchase 2,500 $100 face-value bonds of Alpha Ltd. at their current market price of $95 per bond and then sell them in one year's time. Assuming that the analyst's projections are correct, what after-tax rate of return should you expect to earn on your investment in Alpha Ltd. bonds?

b. The common shares of Delta Company are currently trading at a price of $5 per share. These shares have paid a dividend of $0.25 per share over the most recent year and the financial analyst has advised you that these dividends are expected to grow at an average annual rate of 2% over the foreseeable future. The analyst has also advised you that the common shares of Delta Company have a beta of 1.10, the risk-free rate of interest is 3%, and the market price of risk is 5%. Finally, the analyst has informed you that, according to their projections, the shares are appropriately priced. Based on the analyst's advice, you have decided to purchase 75,000 common shares of Delta Company at their current price. Assuming the analyst's projections are correct, what after-tax rate of return should you expect to earn on your investment in Delta Company common shares over a one-year period?

Text Box: f. Based on the calculations in part (e), comment on whether the portfolio is undervalued or overvalued and explain why. Given the valuation of the portfolio, indicate if it lies above or belowc. If you decide to invest in a portfolio which consists of 2,500 of Alpha's $100 face-value bonds, 75,000 common shares of Delta Company, and 2,000 $100 face value one-year treasury bills, which are currently priced at $98, what is the expected after-tax rate of return on your investment portfolio over a one-year period? (3 marks)

Question 2:

AZN Ltd. and BCA Inc. are direct competitors within the financial services industry. While of similar size and offering similar products and services, historically BCA has been significantly more profitable and has paid a larger and more stable dividend. The two companies have also adopted quite different capital structures, with AZN using considerably more long-term debt and less common equity than BCA.

You have recently consulted with your financial advisor who has offered the following information about the common shares of these two companies.

	AZN Ltd.	BCA Inc.
Expected return	12%	10%
Standard deviation of return	21%	13%
Beta	1.70	0.80

In order to diversify your portfolio, your financial advisor has also suggested that you might invest a part of your funds in Government of Canada treasury bills with a maturity of one year, and a part in the common shares of MK] Ltd., a company that operates in the manufacturing sector. The common shares of HKJ have an expected return of 11%, a standard deviation of return of 18%, and a beta of 1.25.

Finally, your financial advisor has informed you that the current risk-free interest rate is 2.5% and the market price of risk is 6%.

a. Based on the information provided in the table above, what are the required rates of return for both AZN and BCA common shares?

b. Based on your calculations from part (a) and the table above, should you invest in the shares of either AZN or BCA?

c. What is the standard deviation of return of a portfolio composed of 40% BCA common shares and 60% HKJ common shares if the correlation between their two returns is 0.55?

d. What is the beta of a portfolio composed of 40% BCA common shares and 60% HKJ common shares?

e. Assume that you have decided to invest one-half of your funds in the one-year treasury bills and one-half in the portfolio composed of 40% BCA common shares and 60% HKJ common shares. Determine each of the following figures:

• The expected return on the investment
• The standard deviation of return on the investment
• The beta of the investment
• The required rate of return on the investment

f. Based on the calculations in part (e), comment on whether the portfolio is undervalued or overvalued and explain why. Given the valuation of the portfolio, indicate if it lies above or below the security market line (SML).

g. Is it possible for a security to be underpriced or overpriced at any point in time? Briefly explain why this may happen and, if it does happen, what role financial reporting can play to promote efficient capital markets.

Question 3:

Circus Inc., a large producer of novelty items, has recently committed to an aggressive expansion plan that will almost double the firm's capacity. Given the magnitude of the plan, the choice of financing (debt or equity) has the potential to significantly alter Circus' capital structure. To develop a better understanding of what constitutes its optimal capital structure and thereby the best mix of financing to raise for the expansion, management has asked you to estimate its current weighted average cost of capital (WACC). In order to complete this task, you have been provided with the following information.

Based on its most recent balance sheet, Circus has been financed equally with the use of long-term debt and common equity. Circus currently has a $200 million face value long-term debt issue outstanding and its 50 million common shares also have a book value of $200 million. The bonds have seven years remaining until maturity and carry a 4% coupon rate that is payable semi-annually. Over the most recent year, the common shares paid a dividend of $0.25 per share and analysts have forecasted this dividend to grow at an average annual rate of 3% for the foreseeable future. The analysts have also stated that they believe that the shares will be selling at a price of $5.25 in one year's time.

Circus has been advised by its underwriters that flotation costs would be 6% before tax on any new bond issues and 4% after tax on new issues of common equity. Finally, Circus' marginal tax rate is 29%, the current price of its bond issue is $97 per $100 face value bond, and its common shares are currently trading at a price of $5.00 per share.

Required

a. Determine the appropriate weights to use in determining Circus' WACC.

b. Calculate Circus' cost of debt and cost of issuing new common equity.

c. Based on your calculations in parts (a) and (b), estimate Circus' WACC, assuming that it will raise new common equity.

d. If Circus decides to raise the additional financing exclusively via a new bond issue, briefly explain for each whether its cost of debt, cost of common equity, and WACC will increase or decrease?

Question 4:

Nelson Holdings, a vintner located in the Okanagan Valley in British Columbia, is considering opening a distribution centre in Moncton, New Brunswick. The proposed site for the centre is a block of land that Nelson purchased two years ago for $250,000. An independent appraiser has indicated it is now worth $400,000, and is projected to be worth $600,000 at the end of Nelson's six-year planning horizon.

Underlying its decision to now formally evaluate the viability of the new distribution centre is a positive market survey recently conducted at a cost of $100,000. The results of the survey indicate that there will be considerable interest for Nelson's various product lines in Eastern Canada.

The projected cost of the building for the centre is $1 million. In addition, Nelson will have to make a $200,000 investment in net working capital to support the operation, and this investment will be released at the end of the planning horizon. The building will be depreciated on a straight-line basis to zero salvage for accounting purposes over the six-year period. The applicable CCA rate on the building is 10% and the independent appraiser believes that the building will be worth $250,000 in six years.

Based on the market survey, Nelson believes that the distribution centre will generate incremental before-tax cash flows of $300,000 each year over the planning horizon. Finally, Nelson's marginal tax rate is 35%, its WACC is 12%, and management believes that the appropriate risk-adjusted discount rate for the project is 15%.

Required

a. Estimate the initial after-tax cash outlay for the proposed project. In your response, identify costs listed above that you have decided not to include and explain why they have not been included.

b. Estimate the net present value (NPV) associated with the proposed distribution centre and indicate whether Nelson should accept the proposed project.

c. Nelson currently has 500,000 common shares outstanding. Based on your solution to part (b), if the company decides to go ahead with the proposed distribution centre, what should be the change in the price of these common shares if markets are efficient? Briefly explain your answer.

Question 5:

When financing a new project, a firm's decision to issue either new debt or new equity can result in different capital structures. For example, the decision to issue new debt will result in a much higher leveraged capital structure than the decision to issue equity. One way that a firm can decide whether a high leverage or a low leverage alternative is more appropriate is to determine the firm's EPS indifference EBIT level (EBIT*).

Required

a. Explain what the EPS indifference EBIT is and how the EPS indifference EBIT can be used to assist a firm in making a choice between high-leverage and low-leverage alternatives for its capital structure.

b. Assume that LaLa Inc. is trying to decide between a capital structure with a debt-to-equity (D/E) ratio of 2.00 and a D/E ratio of 0.75. Under the high-leverage alternative, LaLa will have outstanding debt with an average coupon rate of 5% and a face value of $375 million, and 50 million common shares outstanding. Alternatively, under the low-leverage alternative, LaLa will have outstanding debt with an average coupon rate of 4% and a face value of $200 million, and 85 million common shares outstanding. Lab has a tax rate of 31%.

Based on this information, and assuming that its expected EBIT is $30 million, determine LaLa's EPS indifference EBIT and indicate which of these two capital structure alternatives would be better for LaLa.

Question 6:

a. What are the potential advantages and disadvantages to a company's shareholders if the company increases the proportion of debt in its capital structure?

b. Identify four main factors that a CFO needs to consider when evaluating a firm's capital structure.

c. What type of cash dividend policy (zero, low, or high) should a start-up company that is undergoing significant growth follow and why? Identify two possible substitutes for cash dividends and briefly explain why they are reasonable substitutes.

Question 7:

a. Upon recent receipt of an engineering report, the management of the Bedford Basis Company (BB Co.) has concluded that one of the cranes at its dry dock facility must be replaced. The report reveals that the crane is beyond repair and can only be sold for $500,000 as scrap metal. Management is now trying to decide whether the new crane should be leased or purchased.

If purchased, the new crane will cost $5 million to acquire. At the end of its 15-year useful life, its estimated salvage value will be $1 million. The applicable CCA rate on the crane is 7.5%. Alternatively, if the crane is leased, BB Co. will have to make lease payments of $500,000 at the beginning of each year over the 15-year term of the lease. Given advances in technology, employees operating the crane will have to receive additional training at a cost of $100,000. These training costs will be expensed in the current period for both tax and accounting purposes. Finally, repairs and maintenance costs on the new crane will average $125,000 per year over the 15-year operating life of the crane. BB Co. will incur these costs irrespective of whether it decides to lease or purchase the new crane.

If BB Co.'s WACC is 14%, its after-tax cost of debt is 8%, and its tax rate is 27%, determine whether it should lease or purchase the new crane.

b. While a firm may have a preferential dividend policy, there are four factors that may limit its ability to follow this preferred policy. Identify and briefly describe each of these four factors.

Question 8:

a. Explain why capital investment decisions should be based on project cash flows and not their accounting income.

b. Identify the two major complications associated with the internal rate of return (IRR) method of capital budgeting and explain why they develop.

c. What are the criteria for choosing between projects under each of the following capital budgeting methods: NPV, IRR, and PBP? Will the decision be the same under all three methods? Explain why or why not.

Text Box: c. Explain why informational efficiency is fundamental to the existence of well-functioning capital markets. (4 marks)Question 9 (9 marks)

Question 9:

Omega Inc. is a diversified company that is currently composed of three divisions of equal size that operate in unrelated industry sectors. Omega is now considering expanding into a fourth unrelated industry sector.

a. Is it appropriate for Omega to use its current WACC to evaluate this proposed expansion plan? Explain why or why not.

b. Assume that the divisional betas for each of the three current divisions are 0.8, 1.1, and 1.4, and the beta of the potential new division is 1.6. If the market price of risk is 6% and the risk-free rate is 2%, what are the appropriate risk-adjusted discount rates for Omega as it currently exists and for the potential new division?

c. What would be the potential implications for Omega if it uses its current WACC to evaluate the proposed expansion into the fourth division?

Question 10

a. If a security has a beta that is greater than 1 and the security offers an expected return that is lower than the expected return on the market portfolio, is the security overpriced or underpriced?

b. For each of the following two situations, explain whether it is a situation of informational efficiency or inefficiency.

Situation #1:
Situation #2:

Historically, you have waited until the weekend after receiving the financial statements of the Bank of Montreal (BMO) to read them and make your decision about buying or selling BMO shares. Your experience has been that you rarely make a profit on your trading strategy In BMO shares.

With your analytical skills, you can typically complete a thorough analysis of a company within a matter of minutes following the release of its financial statements. Your experience has been that you typically make a profit on your trades.

c. Explain why informational efficiency is fundamental to the existence of well-functioning capital markets.