# expected net present value of the project

Question 1. Otel Corporation entered into an agreement with its investment banker to sell 15 million shares of the company's stock with Otel netting $270 million dollars from the offering.

The out-of-pocket expenses incurred by the investment banker were $5,000,000.

a. What profit or loss would the investment banker incur if the issue sold to the public at an average price of $25 per share?

b. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $15 per share?

c. Is this an example of a negotiated deal or best efforts? Why? Who bears the greater risk, the investment banker or the company? Why?

d. If the investment banker agrees to handle the issue on a best efforts basis, earning 7.5 percent of the proceeds, calculate the investment banker's profit or loss if all 15 million shares are sold at an average price of $15. How much will the company receive?

e. Who bears the greater risk in a best efforts deal, the investment banker or the company? Why?

Question 2. Differentiate between each of the following and provide a specific example to illustrate each answer.

a. A golden parachute and a poison pill.

b. A friendly merger and a hostile merger.

c. A vertical merger and a horizontal merger.

d. An acquiring company and a target company

e. Purchase accounting and pooling of interest accounting

Problem 3. Campbell Company's balance sheet and income statement are shown below (in millions of dollars). The company and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the $4 preferred will be exchanged for one share of $1.50 preferred with a par value of $50 plus one 10 percent subordinated income debenture with a par value of $50. The $6 preferred issue will be retired with cash.

Current Current

Current Assets 250.0 Current liabilities 275.0

Net fixed assets 195.0 Advance payments 15.00

$4 preferred stock, $100 par value (1,000,000) shares 100.0

$6 preferred stock, no par, callable at 10 (800,000 shares) 8.0

Common stock, $0.50 par value (20,000,000) shares 10.0

Retained earnings 37.0

Total assets 445.0 Total claims 445.0

a. Construct the pro forma balance sheet after reorganization takes place. Show the new preferred at its par value.

b. Construct the pro forma income statement after reorganization takes place. How does the recapitalization affect net income available to common stockholders?

Income Statement

Current

Net sales 600.0

Operating expense 550.0

Net operating income 50.0

Other income 10.0

EBT 60.0

Taxes 9.0 15%

Net income 51.0

Dividends on $4 PS 4.0

Dividends on $6 PS 4.8

Income to Common SHs 42.2

c. What are the required pre-tax earnings before and after the reorganization?

d. Calculate the debt ratio before and after the reorganization?

e. Would the common stockholders be in favor of the reorganization? Why or why not?

Problem 4. A Treasury bond futures contract settles at 105-8.

a. What is the present value of the futures contract?

b. If the contract settles at 105-8, are current market interest rates higher or lower than the standardized rate on a futures contract? Explain.

c. What is the implied annual interest rate on the futures contract?

d. Calculate the new value of the futures contract if interest rates increase by 1 percentage point annually.

e. Calculate your profit or loss if you sold a futures contract at 105-8 and purchased an offsetting contract when rates increased by 1 percentage point annually.

Question 5. Your portfolio is diversified . It has an expected return of 11.0% and a beta of 1.10. You want to add 300 shares of Tundra Corporation at $40 a share to your portfolio. Tundra has an expected return of 13.0% and a beta of 1.50. The total value of the investor's current portfolio is $45,000.

a. Calculate the expected return on the portfolio after the purchase of the Tundra stock?

b. Calculate the expected beta on the portfolio after you add the new stock?

c. Is your portfolio less risky or more risky than average? Explain.

d. Will your portfolio likely outperform or underperform the market in a period when stocks are rapidly falling in value?

e. Is beta always an accurate predictor of a portfolio's performance? Explain?

Question 6. Calhoun Resorts is interested in developing a new facility in Toronto. The company estimates that the hotel would require an initial investment of $10 million. The company expects that the facility will produce positive cash flows of $2,710,000 a year at the end of each of the next 5 years. The project's cost of capital is 11%.

a. Calculate the expected net present value of the project.

b. The company recognizes that the cash flows could be higher or lower than 2,710,000, depending on whether the host government imposes a facility tax. The company will know in one year whether the tax will be imposed. There is a 30 percent chance that the tax will the imposed, in which case the yearly cash flows will be only $2.5 million. At the same time, there is a 70 percent chance that the tax will not be imposed, in which case the yearly cash flows will be $3.2 million. The company is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it waits year, the initial investment will remain at $10 million and positive cash flows will continue for 5 years. Assume that all cash flows are discounted at 11 percent. Using decision tree analysis, calculate the value of the real option to wait a year before deciding.

c. Discuss 2-3 factors other than the value of the real option that the company should consider in making its decision.

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#### Solution Summary

This solution clearly calculates the expected net present value of the project.

Capital Budgeting, portfolio returns and standard deviation

7. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year Project A Project B

1 . . . . . . . . . . $12,000 $10,000

2 . . . . . . . . . . 8,000 6,000

3 . . . . . . . . . . 6,000 16,000

a. Which of the two projects should be chosen based on the payback method?

b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

c. Should a firm normally have more confidence in answer a or answer b?

15. The Danforth Tire Company is considering the purchase of a new machine that

would increase the speed of manufacturing and save money. The net cost of this

machine is $66,000. The annual cash flows have the following projections.

Year Cash Flow

1. . . . . . . . . $21,000

2. . . . . . . . . 29,000

3. . . . . . . . . 36,000

4. . . . . . . . . 16,000

5. . . . . . . . . 8,000

a. If the cost of capital is 10 percent, what is the net present value?

b. What is the internal rate of return?

c. Should the project be accepted? Why?

20. Miller Electronics is considering two new investments. Project C calls for the purchase of a coolant recovery system. Project H represents an investment in a heat recovery system. The firm wishes to use a net present value profile in comparing the projects. The investment and cash flow patterns are as follows:

Project C Project H

($25,000 investment) ($25,000 investment)

Year Cash Flow Year Cash Flow

1 . . . . . . . . . . . . . .$ 6,000 1 . . . . . . . . . . . . . . .$20,000

2 . . . . . . . . . . . . . . .7,000 2 . . . . . . . . . . . . . . . . .6,000

3 . . . . . . . . . . . . . . .9,000 3 . . . . . . . . . . . . . . . . .5,000

4 . . . . . . . . . . . . . .13,000

a. Determine the net present value of the projects based on a zero discount rate.

b. Determine the net present value of the projects based on a 9 percent discount rate.

c. The internal rate of return on Project C is 13.01 percent, and the internal rate of return on Project H is 15.68 percent. Graph a net present value profile for the two investments similar to Figure 12-3. (Use a scale up to $10,000 on the vertical axis, with $2,000 increments. Use a scale up to 20 percent on the horizontal axis, with 5 percent increments.)

Chapter 13 Problems

1. Myers Business Systems is evaluating the introduction of a new product. The

possible levels of unit sales and the probabilities of their occurrence are given

below:

Possible Sales

Market Reaction in Units Probabilities

Low response . . . . . . . . . . . . . 20 .10

Moderate response . . . . . . . . . 40 .30

High response . . . . . . . . . . . . . 55 .40

Very high response . . . . . . . . . 70 .20

a. What is the expected value of unit sales for the new product?

b. What is the standard deviation of unit sales?

5. Five investment alternatives have the following returns and standard deviations of returns.

Returns- Standard

Alternative Expected Value Deviation

A. . . . . . . . . . $ 5,000 $1,200

B. . . . . . . . . . . 4,000 600

C. . . . . . . . . . . 4,000 800

D. . . . . . . . . . . 8,000 3,200

E. . . . . . . . . . . 10,000 900

Using the coefficient of variation, rank the five alternatives from lowest risk to highest risk.

14. Mr. Monty Terry, a real estate investor, is trying to decide between two potential small shopping center purchases. His choices are the Wrigley Village and Crosley Square. The anticipated annual cash inflows from each are as follows:

Wrigley Village Crosley Square

Yearly Aftertax Yearly Aftertax

Cash Inflow Cash Inflow

(in thousands) Probability (in thousands) Probability

$10 . . . . . . . . . . . .1 $20 . . . . . . . . . . . .1

30 . . . . . . . . . . . .2 30 . . . . . . . . . . . .3

40 . . . . . . . . . . . .3 35 . . . . . . . . . . . .4

50 . . . . . . . . . . . .3 50 . . . . . . . . . . . .2

60 . . . . . . . . . . . .1

a. Find the expected value of the cash flow from each shopping center.

b. What is the coefficient of variation for each shopping center?

c. Which shopping center has more risk?