1) At the end of 2005, Uma Corporation was considering undertaking a major long-term project in an effort to remain competitive in its industry. The production and sales departments determined the potential annual cash flow savings that could accrue to he firm if it acts soon. Specifically, they estimate that a mixed stream of future cash flow savings will occur at the end of the years 2006 through 2011. The years 2012 through 2016 will see consecutive and equal cash flow savings at the end of each year. The firm estimates that its discount rate over the first 6 years will be 7%. The expected discount rate over the years 2012 through 2016 will be 11%.
The project managers will find the project acceptable if it results in present cash flow savings of at least $860,000. The following data is available to assist you:
a) Determine the value - at the beginning of 2006 - of the future cash flow savings expected to be generated by this project.
b) Should the firm undertake this project? Why or why not?
Present Value of Expected Future Savings
Period: 2006 through 2016
Note: This is a compound TVM problem
Discount rate for years 2006 - 2011 7%
Discount rate for years 2012 - 2016 11%
Year Period Savings PVIF PVIFA Value
2006 1 $110,000
2007 2 120,000 Please note that there is an annuity for years 7 to 11 that you first should find the PV of and then
2008 3 130,000 discount that value back to year 1
2009 4 150,000
2010 5 160,000
2011 6 150,000
2012 7 90,000
2013 8 90,000
2014 9 90,000
2015 10 90,000
2016 11 90,000
2) Chapter 7 Stock Valuation
You are interested in purchasing the common stock of Azure Corporation. The firm recently paid a dividend of $3 per share. It expects its earngins - and hence its dividends - to grow at a rate of 7% for the foreseeable future. Currently, similar risk stocks have required returns of 10%. (a) Given the data, calculate the present value of this security usign the constant-growth model in Ch. 7 to find the stock value. One year later your broker offers to sell you additional shares of Azure at $73. The most recent dividend paid was $3.21, and the expected growth rate for earnings remains at 7%. To determine the required rate of return you must use the capital asset pricing model (CAPM). The risk-free rate is currently 5.25%, the market return is 11.55% and the stock's beta is 1.07. Substittue the appropriate values into the CAPM to determine the firm's current required rate of return. (b) Once this required rate of return is found determine the value
of the stock.
Most Recently Paid Dividend $3.00 Do
Growth Rate in Earnings 7% g
Required rate of return 10% k
Current Price of stock Po = [a]
One year later:
Most Recently Paid Dividend Do
Growth Rate in Earnings g
t-bill rate Rf
Market portfolio return km
beta of Azure Corporation beta
Capital Asset Pricing Model (CAPM)
CAPM: knew = Rf + (km - Rf)*betaazure
New required return knew [b]
3) Leverage and Capital Structure - chapter 12
Calculation of Share Value
Estimates Associated with
Alternative capital Structures
Capital Structure Expected Estimated Estimated
Debt Ratio EPS Required Return Share Value
0% $1.75 11.40%
10 1.90 11.80%
20 2.25 12.50%
30 2.55 13.25%
40 3.18 18.00%
50 3.06 19.00%
60 3.10 25.00%
Given the above estimates of EPS and required rates of return based on increasing levels of debt for this organization, calculate the estimated share price value for each level using a common stock valuation model from chapter 11.
Assuming the organization makes decisions considering how best to maximize shareholder wealth, at what debt ratio will this objective be realized?
This solution explains the calculations and answers for the finance questions relating to time value of money, stock valuation and capital structure. This solution is included in an attached Excel file.