Financial Management I – Online
Assignment #2
Chapters 8, 9, 11-15
/95 Marks
Name: Alexander Boutros Date: 2017/04/06
1. Discuss how betas are measured and used for individual stocks. (3 marks)
Beta is a measure of a stock’s volatility in relation to the market. A stock that has a beta of 1, it
follows the market. Beta is measured using the covariance between the return of the security
and the return of the market must be known, as well as the variance of the market returns.
Depending on the beta of the stock, it displays the volatility of the stock compared to the
market.
2. Calculate the NPV for a project costing $200,000 and providing $20,000 annually for 40 years.
The discount rate is 8 percent. By how much would the NPV change if the inflows were reduced
to 30 years? Would you accept the projects? (5 marks).
• Discount Rate = 8%
Periods = 40 years
Cash Flows = 20,000
Initial Investment = 200,000
NPV = $38,492.27
• Discount Rate = 8%
Periods = 30 years
Cash Flows = 20,000
Initial Investment = 200,000
NPV = 25,155.67
If the inflows were reduced to 30 years, there would be a % change of -34.65%.
25155.67/38492.27 = 65.35 – 100 = -34.65% or 38492.77 – 25155.67 = 13336.60
I would accept both projects since they both have a net present value that is positive.
3. Why is it important to use market values rather than book values when determining the
weighted average cost of capital? (2 marks)
It is important to use market values rather than book values when determining the WACC because
an investor would demand market required rate of return on the market value of capital and not the
book value of capital. If a company used book value, they would have outdated information since
the market value might have changed since they purchased the asset.
4. List four protective covenants that you might be interested in as a prospective bondholder.
Briefly describe why these would be realistic bondholder concerns. Note: the text did not list
four covenants, so you must be creative. (4 marks)
Protective Covenants are restrictions placed on the firm issuing bonds to protect the bondholders.
There are many kinds of protective covenants that bondholders would be interested in knowing
about.
• Covenants that restrict the issuance of new debt
This restriction would be a realistic bondholder concern because the company would not be
able to issue new debt if they need extra capital to finance projects, etc.
• Covenants that restrict dividend payments
This restriction would be a realistic bondholder concern because the company would be
reinvesting their retained earnings into new projects instead of giving money to the owners of
preferred stocks or common stock. This also means that there’s a better chance that their
retained earnings might be used to pay out their callable bonds.
• Covenants that restrict merger activities
This restriction would be a realistic bondholder concern because the company would not be
able to participate in a merger or acquisition with another firm.
• Covenants that restrict the disposition of the firm’s assets
This restriction would be a realistic bondholder concern because the company would not be
able to get rid of any assets that could cause an issue.
5. What is the weighted-average cost of capital for a firm with the following sources of funds and
corresponding required rates of return: $5 million common stock at 16 percent, $500,000
preferred stock at 10 percent, and $3 million debt at 9 percent. All amounts are listed at market
values and the firm’s tax rate is 35 percent. (4 marks)
Common Stock = $5,000,000 Required return = 16%
Preferred Stock = $500,000 Required return = 10%
Debt = $3,000,000 Required return = 9%
Tax Rate = 35%
WACC
= 5,000,000/8,500,000 X 0.16 + 500,000/8,500,000 X 0.10 + 3,000,000/8,500,000 X 0.09 X 0.65
=0.094 + 0.0059 + 0.02 = 0.12 The Weighted Average Capital Cost is 12%.
6. How much is an investor’s tolerance for risk worth over a long horizon? Calculate the difference
in accumulation in real terms for an investor who initially invests $25,000 and ignores it for 20
years in either a long-term Treasury bond portfolio or a portfolio of diversified common stocks.
Assume the historic real returns of 2.1 percent annually for bonds and 9.3 percent for common
stocks. (3 marks)
Bond Portfolio : $25,000(1.021) 20 = 25,000(1.51536) = $37,883.91
Stock Portfolio : $25,000(1.093) 20 = 25,000(5.92111) = $148,027.79
The difference in real terms between the two portfolios is $110,143.87, or more than four times the
amount of the initial investment. This is because of the rate of return being significantly smaller for
the bond portfolio compared to the stock portfolio.
7. Determine the change in net working capital that appears warranted for the following proposed
project: Inventory levels will increase 20% from their current value of $500,000; cash will
increase by $25,000; wage accruals will increase by $60,000; machinery will increase by $75,000;
accounts receivable—because of a new collection system—will increase by only $15,000;
accounts payable will increase by $45,000. What happens to net working capital at the end of
the project’s life? (3 marks)
At the end of the project’s life, the working capital will be equal to $35,000.
Inventory = 500,000 * .20 = 100,000
Cash = 25,000
Accounts Receivable = 15,000
Current Assets = 140,000
Wage Accruals = 60,000
Accounts Payable = 45,000
Current Liabilities = 105,000
Working Capital = Current Assets – Current Liabilities = 140,000 – 105,000 = $35,000
8. CumChan forecasts revenues of $320,000 a year. Variable costs will be $90,000 and rental
expense is $70,000. Depreciation is $20,000. Create an income statement for the shop based on
the estimates. The tax rate is 40 percent. (2 marks)
Income Statement
CumChan
Revenues: 320,000
Variable Costs: ($90,000)
Rental Expense: ($70,000)
EBITDA: 160,000
Depreciation: (-20,000)
EBIT: 140,000
Taxes: (56,000)
Net Income: 84,000
9. Calculate the expected rate of return for the following portfolio, based on a Treasury bill yield of
4% and an expected market return of 13%:
