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Investment in a security, Risk-adjusted net present value

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6.1 (Expected rate of return and risk) Carter Inc. is evaluating a security. One-year Treasury bills are currently paying 9.1 percent. Calculate the investment's expected return and its standard deviation. Should Carter invest in this security?

Probability Return
0.15 6%
0.3 9%
0.4 10%
0.15 15%

10.15) (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two capital-budgeting projects with 5-year lives. The first, project A, is a replacement project; the second, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the risk-adjusted discount rate method and groups projects according to purpose, and then it uses a required rate of return or discount rate that has been preassigned to that purpose or risk class. The expected cash flows for these projects are given here:

Project A Project B
Initial investment -\$250,000 -\$400,000
Cash inflows:
Year 1 \$130,000 \$135,000
Year 2 40,000 135,000
Year 3 50,000 135,000
Year 4 90,000 135,000
Year 5 130,000 135,000

The purpose/risk classes and preassigned required rates of return are as follows:

Purpose Required Rate of Return
Replacement decision 12% Project A
Modification or expansion of existing product line 15
Project unrelated to current operations 18 Project B
Research and development operations 20

Determine each project's risk-adjusted net present value.

Attached you will find the PDF document to some practice study problems.
Study problem 6-1 in Chapter 6, Study problem 10-15 in Chapter 10

Solution Preview

6.1 (Expected rate of return and risk) Carter Inc. is evaluating a security. One-year Treasury bills are currently paying 9.1 percent. Calculate the investment's expected return and its standard deviation. Should Carter invest in this security?

Probability Return
0.15 6%
0.3 9%
0.4 10%
0.15 15%

Probability return return x Probability Difference from mean, i.e.9.85% Difference 2 Probability x Difference 2
0.15 6% 0.90% -3.85% 0.00148225 0.0002223375
=6.%x0.15 =6.% - 9.85% =-0.0385^2 =0.15 x 0.00148225
0.30 9% 2.70% -0.85% 0.00007225 0.0000216750
=9.%x0.3 =9.% - 9.85% =-0.0085^2 =0.3 x 0.00007225
0.40 10% 4.00% 0.15% 0.00000225 0.0000009000
=10.%x0.4 =10.% - 9.85% =0.0015^2 =0.4 x 0.00000225
0.15 15% 2.25% 5.15% 0.00265225 0.0003978375
=15.%x0.15 =15.% - 9.85% =0.0515^2 =0.15 x 0.00265225
1.00 Total= 9.85% 0.00064275

Expected ...

Solution Summary

Answers 2 questions on evaluating a security for investment and risk-adjusted net present value.

\$2.19

Financial questions relating to Business Organization, Shareholders' wealth, Cash flow statement, financial ratios, time value of money, CAPM, Bonds, payback, NPV, IRR, IOS and MCC schedule, WACC, Leverage, EBIT-EPS approach, Cash Conversion cycle.

1) Explain the three principal forms of business organization. Outline their respective advantages and disadvantages. How do taxes, risk, scale, and ownership liquidity affect the selection of one of these three methods?

2) Compare the shareholder-wealth-maximization model with the corporate-wealth- maximization model. What is the proxy for shareholder wealth? How does the role of the shareholder conflict with that of other stakeholder? Who are some of the stakeholder and give examples of potential conflicts. Additionally, what is meant by the agency problem, why does it arise, and what may be done to address it?

3) Discuss the three components of a cash flow statement. What is another name for the statement of cash flows and why is the cash flow statement important? How is the statement of cash flows similar or different from a cash budget?

4) Outline the five classes of financial ratios (you do not need to give the formulas). What are the advantages and disadvantage to using ratio analysis? What do you need to be mindful of when doing ratio analysis? What is the DuPont ratio, what are its components, and why is it important?

5) Time value of money

a) What is the difference between compounding and discounting?

b) What are the five variables in a time value calculation?

c) What is the difference between an annuity and a mixed cash flow?

d) What is the difference between an ordinary annuity and an annuity due? Which has a greater future value and why?

e) Give examples where you may use time value in your own life.

6) How do you measure the return and total risk for a single asset? What is the difference between portfolio risk and stand alone risk? What is the difference between systematic risk and unique risk? What is the tradeoff between risk and return? How does risk change (absolutely and incrementally) as you randomly add assets to a portfolio? What effect does
the risk of a single asset and the correlation between assets in a portfolio have on portfolio risk?

7) What is the capital asset pricing model (CAPM); what does it show; why is it important: and how do you use it? What are some of the practical and theoretical limitations of the CAPM?

8) Describe and compare the zero-growth, constant-growth, and multi-stage dividend growth models for equity valuation. What assumptions must you make? How do changes in the growth rate and the cost of capital affect valuation?

11) Bonds

a) Using a bond price yield curve, discuss in detail the relationship between bond prices and the yield to maturity.

b) How do maturity and the size of the coupon affect the shape of the bond price yield curve? Explain. What does the shape of the bond price yield curve mean for interest rate risk?

c) Assuming no change in interest rates, what happens to the price of a bond as it approaches maturity? Show this graphically for a par, premium, and discount bond.

d) If you expect interest rates to rise (decline), what kind of bond should you buy? Why?

12) Compare and contrast the payback, NPV and IRR techniques for capital budgeting. What are their respective advantages and disadvantages of each? Will they ever give you different recommendations? If so, which would you prefer and why?

13) Draw and label an NPV profile? What does the profile show? How can you use it to assess an individual project or multiple projects? What factor(s) explains the shape of the NPV profile? What other curve does it resemble?

14) Explain the IOS and MCC schedules. What are they; how are they computed; and how can you use them? What is a break point? Use a graph to illustrate your work. Carefully label this graph.

15) Describe and discuss the following terms. Be sure to include where/why they are important and/or how you can use them.

b) Annualized net present value

c) Scenario analysis

d) Sensitivity analysis

e) Capital rationing

16) Discuss the weighted average cost of capital: what is it, how do you compute it, why it is important, and what it does it mean for new projects. Is the weighted average cost of capital constant over time? Why or why not?

What are the different ways to determine the weights? Why do some firms use a hurdle rate that is higher than the WACC? What are the implications of using a higher hurdle rate to shareholder wealth maximization?

17) Define operating, financial and total leverage as well as the degree of operating, financial, and total leverage. How do you use them and why are they important? Is the degree of operating, financial, and total leverage constant? Explain why or why not. How do operating and financial leverage affect a company's target capital structure and earnings per share? How and why do businesses adjust for the tradeoff between financial and operating
leverage?

18) Conceptually and graphically discuss how you would determine the optimal capital structure for a specific firm. Include a discussion of the EBIT-EPS approach.

19) Describe the cash conversion cycle, its funding requirements, and the strategies for managing it.

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