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Questions involving a company's finances

The basket of goodies costs $300, and is expected to cost $515 next year. The real rate of interest is 2%. Our company, Basic, Inc. has a bond risk premium of 2.5% and a preferred stock risk premium of 3%.

The Market Risk Premium is 4% and Basic has a Beta of 1.25.

Basic's target capital structure is 40% debt, 50% common stock and 10% preferred stock. The corporate income tax rate is 30%.

We are considering two possible projects, both of which cost $1 million to implement. The stream of cash flows from Project A is:

Year 1 = $100,000
Year 2 = $200,000
Year 3 = $300,000
Year 4 = $400,000
Year 5 = $500,000

The stream of cash flows from Project B is

Year 1 = $250,000
Year 2 = $250,000
Year 3 = $250,000
Year 4 = $250,000
Year 5 = $250,000

a) If the projects are mutually exclusive, which would you recommend?

b) If the projects are independent, what course of action would you recommend?

c) Suppose the rate of inflation increases to 2%. Would your recommendation change, which respect to either independent or mutually exclusive projects? (Assume that changes in the inflation rate will have no impact on the expected stream of cash flows from either project.)

d) Suppose the rate of inflation decreased by 1.5% (below the rate you expected at the beginning of the problem), and the tax rate increases by 5%. Would you change your recommendations with respect to either independent or mutually exclusive projects?

e) Suppose you believe that inflation rates would drop substantially in the next six months. In this scenario, you are the only one who believes that inflation rates will drop. Therefore, market-determined interest rates and discount rates are not affected. What actions can you take to benefit from your superior forecasting ability?

2) Career, Inc. just paid a dividend of $2/share, and is expected to pay $2.10/share next year. The rate of growth is constant. Its stock sells for $35/share. The risk-free rate is 6%, and the required return to the market is 12%. What is the Beta of Career, Inc?

3) Startup, Inc pays no dividend in Years 0, 1, 2. It pays $1 per share in year 3, $1.50 a year in Year 4, and $2 in year 5. As of year 5, the growth rate becomes 10%, and the constant growth prevails thereafter. Startup has a Beta of 1.6. The risk-free rate of interest is 5%, and the required return to the Market is 10%. Calculate the market price of Startup's common stock?

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Answer:
(1) Given that,
Real rate of interest=risk free interest=2%
Bond risk premium=2.5%
Preferred stock risk premium=3%
Market risk premium=4%
Beta=1.25
Tax Rate=30%
Now,

Also,
Weight of debt=40%
Weight of common stock=50%
Weight of preferred stock=10%
So,

Project A:
Year Cash Flow Present Value factor @ 5.06% Present value of cash flow
0 ($1,000,000) 1 ($1,000,000)
1 $100,000 0.951837 $95,183.70
2 $200,000 0.905994 $181,198.75
3 $300,000 0.862358 $258,707.53
4 $400,000 0.820825 $328,329.88
5 $500,000 0.781291 $390,645.68
NPV $254,066

Project ...

Solution Summary

This solution answers various questions involving company's finances.

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