Reference no: EM132371609

Problem Set: Risk and Return and Cost of Capital Problems

Complete the following problems from Chapters 8 and 9 in Principles of Managerial Finance:

Problem 1: Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of return for two similar-risk investments, X and Y. Douglas's research indicates that the immediate past returns will serve as reasonable estimates of future returns. A year earlier, investment X had a market value of $20,000, and investment Y had a market value of $55,000. During the year, investment X generated cash flow of $1,500, and investment Y generated cash flow of $6,800. The current market values of investments X and Y are $21,000 and $55,000, respectively.

a. Calculate the expected rate of return on investments X and Y using the most recent year's data.

b. Assuming the two investments are equally risky, which one should Douglas rec-ommend? Why?

Problem 2: Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are under review. After investigating the possi¬ble outcomes, the company made the estimates shown in the following table. The pessimistic and optimistic outcomes occur with a probability of 25%, and the most likely outcome occurs with a probability of 50%.

a. Determine the range of the rates of return for each of the two projects.
b. Which project seems less risky? Why?
c. If you were making the investment decision, which one would you choose? Why? What does this decision imply about your feelings toward risk?
d. Assume that expansion B's most likely outcome is 21% per year and that all other facts remain the same. Does your answer to part c now change? Why?

Problem 3: Portfolio analysis You have been given the historical return data shown in the first table on three assets-F, G, and H-over the period 2016-2019.

Using these assets, you have isolated the three investment alternatives shown in the following table.

a. Calculate the average return over the 4-year period for each of the three alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do you think performed better over this period? Why?

Problem 4: Concept of cost of capital and WACC Mace Manufacturing is in the process of ana¬lyzing its investment decision-making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions, North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.

a. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendation do you think this analyst will make regarding the investment opportunity?
b. Another analyst assigned to study the South facility believes that funding for that
nrniect will cnme from the firm's retained earnings at a c.nst of 16%_ What rec-

Problem 5: Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 7% coupon rate. Because cur¬rent market rates for similar bonds are just under 7%, Warren can sell its bonds for $1,010 each; Warren will incur flotation costs of $30 per bond in this process. The firm is in the 21 % tax bracket.
a. Find the net proceeds from sale of the bond, Nd.
b. Show the cash flows from the firm's point of view over the maturity of the bond.
c. Calculate the before-tax and after-tax costs of debt.
d. Use the approximation formula to estimate the before-tax and after-tax costs of debt.
e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?
a. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendation do you think this analyst will make regarding the investment opportunity?
b. Another analyst assigned to study the South facility believes that funding for that project will come from the firm's retained earnings at a cost of 16%. What rec-ommendation do you expect this analyst to make regarding the investment?
c. Explain why the decisions in parts a and b may not be in the best interests of the firm's investors.
d. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost of capital (WACC) using the data in the table.
e. If both analysts had used the WACC calculated in part d, what recommenda¬tions would they have made regarding the North and South facilities?
f. Compare and contrast the analyst's initial recommendations with your findings in part e. Which decision method seems more appropriate? Explain why.

Problem 6: Calculation of individual costs and WACC Dillon Labs has asked its financial man¬ager to measure the cost of each specific type of capital as well as the weighted average cost of capital (WACC). The WACC is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm's tax rate is 21%.
Debt The firm can sell for $1,020 a 10-year, $1,000-par-value bond paying annual interest at a 7% coupon rate. A flotation cost of 3% of the par value is required.

Preferred stock An 8% (annual dividend) preferred stock having a par value of $100 can be sold for $98. An additional fee of $2 per share must be paid to the underwriters.

Common stock The firm's common stock is currently selling for $59.43 per share. The stock has paid a dividend that has gradually increased for many years, rising from $2.70 ten years ago to the $4 dividend payment that the company just recently made. If the company wants to issue new common shares, it will sell them $1.50 below the current market value to attract inves¬tors, and the company will pay $2 per share in flotation costs.
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock (both retained earnings and new common stock).
d. Calculate the WACC for Dillon Labs.