# Capital Budgeting, Investments, Stocks and Bonds

Question 1:

Comparing Mutually Exclusive Projects

Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $1,910,000 and will last for 3 years. Variable costs are 38 percent of sales, and fixed costs are $139,000 per year. Machine B costs $4,390,000 and will last for 6 years. Variable costs for this machine are 32 percent and fixed costs are $79,000 per year. The sales for each machine will be $8,780,000 per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, the EAC for machine A is $_____Question 1: (6 points)

Question 2:

Bond Price Movements

Bond X is a premium bond making annual payments. The bond pays a 14 percent coupon, has a YTM of 11 percent, and has 20 years to maturity. Bond Y is a discount bond making annual payments. This bond pays a 11 percent coupon, has a YTM of 14 percent, and also has 20 years to maturity. If interest rates remain unchanged, you would expect that 4 years from now, Bonds X and Y will be priced at $ ____ and $_____ , respectively. And in 11 years: $ ____ and $____ . (Round answers to 2 decimal places.)

Question 3:

Capital Gains versus Income*

Consider four different stocks, all of which have a required return of 19 percent and a most recent dividend of $8.50 per share. Stocks W, X, and Y are expected to maintain constant growth rates in dividends for the foreseeable future of 9 percent, 0 percent, and -9 percent per year, respectively. Stock Z is a growth stock that will increase its dividend by 22 percent for the next 2 years and then maintain a constant 10 percent growth rate, thereafter. The dividend yield for Stocks W, X, Y, and Z is percent, percent, percent, and percent, respectively. The expected capital gains yield for the respective stocks is ____ percent, _____ percent,_____ percent, ____and percent. (Input answers as a percent rounded to 2 decimal places, without the percent sign.) Discuss the relationship among the various returns that you find for each of these stocks.

Question 4:

P 12-16. Arithmetic and Geometric Returns

A stock had the following year-end prices and dividends:

Year Price Dividend

---------------------------------------------------------

1 $ 52.22 --

2 52.58 $ 0.55

3 50.56 0.6

4 51.27 0.63

5 62.46 0.72

6 68.53 0.73

The arithmetic and geometric returns for the stock are _____ percent and _____ percent, respectively. (Input answers as a percent rounded to 2 decimal places, without the percent sign.)

Question 5:

Interest Rate Risk

Bond J is a 6 percent coupon bond. Bond K is a 11 percent coupon bond. Both bonds have 11 years to maturity, make semiannual payments, and have a YTM of 8.5 percent. If interest rates suddenly rise by 3 percent, the percentage change in price of Bonds J and K is____ percent and ____ percent, respectively. (Input answers as a percent rounded to 2 decimal places, without the percent sign.)

Question 6:

Problems with Profitability Index

The Robb Computer Corporation is trying to choose between the following two mutually exclusive design projects:

Year Cash Flow (1) Cash Flow (2)

0 -$40,000 -$9,300

1 21,000 5,200

2 21,000 5,200

3 21,000 5,200

The required return is 19 percent.

a. The profitability index for Projects 1 and 2 is___ and ____ , respectively. If Robb Computer applies the profitability index decision rule, it should accept Project . (Round answers to 3 decimal places.)

b. The NPV for Projects 1 and 2 is $____ and $_____ , respectively. If Robb Computer applies the NPV decision rule, it should accept Project . (Round answers to 2 decimal places.)

c. Explain why your answers in (a) and (b) are different.

Question 7:

Calculating EAC

You are evaluating two different silicon wafer milling machines. The Techron I costs $187,000, has a 4-year life, and has pretax operating costs of $39,000 per year. The Techron II costs $328,000, has a 7-year life, and has pretax operating costs of $22,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $20,000. Your tax rate is 34 percent and your discount rate is 13 percent. The Techron I has an EAC of $____ , while the Techron II has an EAC of $_____ (Round answers to 2 decimal places). You prefer Techron . Why?

Question 8:

Comparing Investment Criteria

Consider the following two mutually exclusive projects:

Year Cash Flow (A) Cash Flow (B)

0 -$194,601 -$28,058

1 12,894 11,999

2 27,237 8,872

3 29,159 13,767

4 388,500 13,767

Whichever project you choose. if any, you require a 15 percent return on your investment.

a. The payback period for Projects A and B is ___ and ___ years, respectively. If you apply the payback criterion, you will choose Project . (Round answers to 2 decimal places.)

b. The discounted payback period for Projects A and B is ___ and ___ years, respectively. If you apply the discounted payback criterion, you will choose Project . (Round answers to 2 decimal places.)

c. The NPV for Projects A and B is $___ and $____ , respectively. If you apply the NPV criterion, you will choose Project . (Round answers to 2 decimal places.)

d. The IRR for Projects A and B is percent and percent (Input these answers as a percent rounded to 2 decimal places, without the percent sign), respectively. If you apply the IRR criterion, you will choose Project .

e. The profitability index for Projects A and B is ___ and ____ , respectively. If you apply the profitability index criterion, you will choose Project . (Round answers to 3 decimal places.)

f. Based on your answers in (a) through (e), you finally choose Project . Why?

Question 9:

Interest Rate Risk

Both Bond Sam and Bond Dave have 8 percent coupons, make semiannual payments, and are priced at par value. Bond Sam has 5 years to maturity, wheareas Bond Dave has 12 years to maturity. If interest rates suddenly rise by 2 percent, the percentage change in the price of Bonds Sam and Dave is____ percent and ____ percent, respectively. (Input answers as a percent rounded to 2 decimal places, without the percent sign.)

Question 10:

Calculating Investment Returns

You bought one of Great White Shark Repellant Co.'s 7 percent coupon bonds one year ago for $870. These bonds make annual payments and mature 11 years from now. Suppose you decide to sell your bonds today, when the required return on the bonds is 11 percent. If the inflation rate was 4.3 percent over the past year, your total real return on this investment was ____ percent. (Input answer as a percent rounded to 2 decimal places, without the percent sign.)

Question 11:

Project Analysis

You are considering a new product launch. The project will cost $490,000, have a 3-year life, and have no salvage value; depreciation is straight- line to zero. Sales are projected at 230 units per year; price per unit will be $26,000, variable cost per unit will be $13,000, and fixed costs will be $220,000 per year. The required return on the project is 16 percent, and the relevant tax rate is 37 percent.

a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within +/- 9 percent. Determine the upper and lower bounds for these projections. The base-case NPV is $___ . The best-case NPV is $____ and the worst-case NPV is $___ . (Round answers to 2 decimal places.)

Upper bound Lower bound

Unit sales

Variable cost per unit $

Fixed costs $

b. The sensitivity of your base-case NPV to changes in fixed costs is $ __ . (Round answer to 6 decimal places.)

c. The cash break-even level of output for this project (ignoring taxes) is units. (Round answer to nearest whole number.)

d. The accounting break-even level of output for this project is units (Round answer to nearest whole number). The degree of operating leverage at the accounting break-even point is (Round answer to 2 decimal places). Thus, for every 1 % increase in unit sales, OCF will change by percent (Input answer as a percent rounded to 2 decimal places, without the percent sign).

Question 12:

Nonconstant Growth

Storico Co. just paid a dividend of $3.50 per share. The company will increase its dividend by 24 percent next year and will then reduce its dividend growth rate by 6 percentage points per year until it reaches the industry average of 6 percent dividend growth, after which the company will keep a constant growth rate, forever. If the required return on Storico stock is 23 percent, a share of stock will sell for $ __ today. (Round answer to 2 decimal places.)

Question 13:

P 12-7. Calculating Returns and Variability

Using the following returns, calculate the arithmetic average returns, the variances, and the standard deviations for X and Y.

For average return and standard deviation: (Input answers as a percent rounded to 2 decimal places, without the percent sign.)

For variance: (Round answers to 4 decimal places.)

Returns

---------------------------------------------

Year X Y

-------------------------------------------------------------------------------

1 -7 % 29 %

2 1 41

3 19 -12

4 -6 25

5 8 16

X Y

Average Return

%

%

Variance

Standard Deviation

%

%

Question 14:

Coupon Rates

Rhiannon Corporation has bonds on the market with 15.5 years to maturity, a YTM of 11.2 percent, and a current price of $810.73. The bonds make semiannual payments. The coupon rate on these bonds must be ___ percent. (Input answer as a percent rounded to 2 decimal places, without the percent sign.)

Question 15:

Calculating Real Rates of Return

If Treasury bills are currently paying 8 percent and the inflation rate is 5 percent, the approximate real rate of interest is __ percent. The exact real rate is ___ percent. (Input answers as a percent rounded to 2 decimal places, without the percent sign.)

Question 16:

Stock Values

The Jackson-Timberlake Wardrobe Co., just paid a dividend of $1.22 per share on its stock. The dividends are expected to grow at a constant rate of 6 percent per year, indefinitely. If investors require a 10 percent return on The Jackson-Timberlake Wardrobe Co., stock, the current price is $___ . The price will be $___ in 19 years. (Round answers to 2 decimal places.)

#### Solution Summary

Answers questions on Comparing Mutually Exclusive Projects, Bond Price Movements, Capital Gains versus Income, Arithmetic and Geometric Returns, Interest Rate Risk, Profitability Index, EAC, NPV, Interest Rate Risk, Investment Returns, Project Analysis, Stock price with non constant growth in dividends, average return and standard deviation of return, Coupon Rates, Real Rates of Return, Stock Values