1. A company is considering a project that requires an initial investment of $100 million and will pay $20 million of each of the next 10 years, and nothing thereafter. The company undertook another project in the same line of business two years ago. The internal rate of return on that project was 20%. The company is considering using 20% as the discount rate for its current project, arguing that it is the "return on a project of comparable risk" to the current project. Is this justified? Argue why, or why not. If you disagree with the company's method of finding the discount rate, suggest an alternative.
2. A company manufacturing household electrical products is planning a major expansion in a particular segment of the high tech sector. This will fundamentally change the nature of the firm's business. The company just paid a dividend per share of $1, and the growth rate of dividends so far has been fairly stable at 3% per year, and would have been expected to remain at that level had the company not changed direction. If the company enters the new line of business, it is expected that dividends will grow at the rate of 5% per year. After the change, the company's existing assets in the household electrical products division will constitute 60% of its total assets, while its assets in the high tech division will constitute 40% of its overall assets. The asset beta of a firm in the household electrical products industry is 0.8. The asset beta of a firm in the high tech sector producing similar products as the firm is 1.8. The risk free interest rate is 4% and the market risk premium is 10%. The firm has a policy of not having any debt on its balance sheet. The company management has just called a press conference to announce its expansion plan.
Please answer the following questions: (a) what is the likely impact of the announcement on the company's stock price (b) if the stock was trading at $10.5 per share the day before the announcement, do you think the news of the company's plans had somehow leaked to the market?
3. The market-to-book asset ratio (MBA ratio) is defined as the ratio of the market value of a company to the book value of its assets. Recall that the market value is the present value of cash flows, or the sum of the market value of debt and equity. The MBA ratio is often considered a performance measure. For example, if a company has an MBA ratio of 1.5, this means that for every dollar invested in assets, the company has created an extra 50 cents. Therefore, companies with MBA ratio above (below) 1 are deemed to have created (wasted) value. Companies with higher MBA ratios are deemed to be performing better.
Now consider a company that has 3 divisions. Division 1 produces Electronic Goods, Division 2 produces Food Products, and Division 3 produces Apparel. You are asked to evaluate this company's performance. You are given the following information. The average market-to-book ratio of assets (MBA ratio) for companies that are "pure plays" in each of these three lines of business are, respectively, 1.2, 1.7 and 1.3. The book values of the company's assets in these three divisions are, respectively, 20 million, 30 million, and 40 million. The company has 40 million in debt, and 5 million shares. Its current share price is $13 per share. Do you think this company is performing well? Please justify your answer.
4. A company's sales will be $20 million and its cost of goods sold will be $10 million every year in perpetuity. Depreciation is $2 million every year in perpetuity, and capital spending every year is exactly equal to depreciation. The level of Net Working Capital will remain unchanged at $1 million every year throughout its life. The company is in the 30% tax bracket. The target debt equity ratio for the company is 1. The cost of debt is 6%. The risk free rate of interest is 3%, and the market risk premium is 10%. The beta of the company's equity is 1.7. The company has 2 million shares. Please find the following:
(a) The cash flow every year.
(b) The weighted average cost of capital (wacc)
(c) What its share price should be.
5. On April 20, 2003, Keystone Corporation made a public equity issue (an issue to the general public, not only to existing shareholders) and raised 2 billion dollars. For the two years prior to that date, the stock price of Keystone had outperformed the market index by an average of 2% per month, and a value weighted industry index by an average of 1.2% per month. On the day the equity issuance plan was announced, the stock price declined 3%. Over the three years after the equity issuance (May 2003-May 2006), the stock price underperformed the market index by an average of 0.5% per month and a value weighted industry index by 0.8% per month. Research has revealed that Keystone's experience is not unique. Many firms that issued equity in the US had experienced qualitatively similar stock price movements.
How do you explain this pattern of stock price behavior for equity issuers