The total market value of the common stock of the Okefenokee Real Estate

Professor: Victor Filipe Martins-da-RochaMonitor: Christiam Miguel Gonzales-Chávez Principles of Corporate FinanceEPGE-FGV 2nd Semester 2009, QuestionsCapital Budgeting and Risk Question 1. The total market value of the common stock of the Okefenokee Real EstateCompany is $6 million, and the total value of its debt is $4 million. The treasurer estimatesthat the beta of the stock is currently 1.5 and the expected risk premium on the market is 6%.The Treasury bill rate is 4%. Assume for simplicity that Okefenokee debt is risk-free and thecompany does not pay tax.(a) What is the required return on Okefenokee stock?(b) Estimate the company cost of capital.(c) What is the discount rate for an expansion of the company’s present business?(d) Suppose the company wants to diversify into manufacture of rose-colored spectacles.The beta of unleveraged optical manufactures is 1.2. Estimate the required return onOkefenokee’s new venture.Question 2. Nero Violins has the following capital structure: (a) What is the ?rm’s asset beta? (Hint: What is the beta of a portfolio of all the ?rm’ssecurities?)(b) Assume that the CAPM is correct. What discount rate should Nero set for investmentsthat expand scale of its operations without changing its asset beta? Assume a risk-freeinterest rate of 5% and a market risk premium of 6%.Question 3. The following table shows estimates of the risk of two well-known Canadianstocks: (a) What proportion of each stock’s risk was market risk, and what proportion was uniquerisk? (b) What is the variance of Alcan? What is the unique variance?(c) If the CAPM is correct, what is the expected return on Alcan? Assume a risk-free interestrate of 5% and an expected market return of 12%.(d) Suppose that next year the market provides a zero return. Knowing this, what returnwould you expect from Alcan?Question 4. You are given the following information for Golden Fleece Financial: Calculate Golden Fleece’s company cost of capital. Ignore taxes.Question 5. We concentrate on Burlington Northern described in the following table. (a) Calculate Burlington’s cost of equity from the CAPM using its own beta estimate and theindustry beta estimate. How different are you answers? Assume a risk-free rate of 5%and a market risk premium of 7%.(b) Can you be con?dent that Burlington’s true beta is not the industry average?(c) Under what circumstances might you advise Burlington to calculate its cost of equitybased on its own beta estimate?(d)Question 6. You run a perpetual machine, which generates revenues averaging $20 millionper year. Raw material costs are 50% of revenues. These costs are variable–they are alwaysproportional to revenues. There are no other operating costs. The cost of capital is 9%. Your?rm’s long-term borrowing rate is 6%.Now you are approached by Studebaker Capital Corp., which proposes a ?xed-price contractto supply raw materials at $10 million per year for 10 years. 2 (a) What happens to the operating leverage and business risk of the machine if you agreeto this ?xed-price contract.(b) Calculate the present value of the machine with and without the ?xed-price contract.Question 7. Mom and Pop Groceries has just dispatched a year’s supply of groceries to thegovernment of the Central Antarctic Republic Payment of $250,000 will be made one yearhence after the shipment arrives by snow train. Unfortunately there is a good chance ofa coup d’état, in which case the new government will not pay. Mom and Pop’s controllertherefore decides to discount the payment at 40%, rather than at the company’s 12% cost ofcapital.(a) What’s wrong with using a 40% rate to offset political risk?(b) How much is the $250,000 payment really worth if the odds of coup d’état are 25%?Question 8. An oil company is drilling a series of new wells on the perimeter of a producingoil ?eld. About 20% of the new wells will be dry holes. Even if a new will strikes oil, there isstill uncertainty about the amount of oil produced: 40% of new wells that strike oil produceonly 1,000 barrels a day; 60% produce 5,000 barrels per day.(a) Forecast the annual cash revenues from a new perimeter well. Use a future oil price of$15 per barrel.(b) A geologist proposes to discount the cash ?ows of the new wells at 30% to offset therisk of dry holes. The oil company’s normal cost of capital is 10%. Does this proposalmake sense? Brie?y explain why or why not.Question 9. Consider the following project. Now assume that(a) Expected cash ?ow is $150 per year for ?ve years.(b) The risk-free rate of interest if 5%.(c) The market risk premium is 6%.(d) The estimated beta is 1.2.Calculate the certainty-equivalent cash ?ows, and show that the ratio of these certaintyequivalent cash ?ows to the risky cash ?ows declines by a constant proportion each year.3 Question 10. A project has the following forecasted cash ?ows: The estimated project beta is 1.5. The market return rm is 16%, and the risk-free rate r f is7%.(a) Estimate the opportunity cost of capital and the project’s PV (using the same rate todiscount each cash ?ow).(b) What are the certainty-equivalent cash ?ow to the expected cash ?ow in each year?(c) What is the ratio of the certainty-equivalent cash ?ow to the expected cash ?ow in eachyear?(d) Explain why this ratio declines.Question 11. The McGregor Whisky Company is proposing to market diet scotch. The product will ?rst be test-marketed for two years in shouthern California at an initial cost of$500,000. This test launch is not expected to produce any pro?ts but should reveal consumerpreferences. There is a 60% chance that demand will be satisfactory. In this case McGregorwill spend $5 million to launch the scotch nationwide and will receive an expected annualpro?t of $700,000 in perpetuity. If demand is not satisfactory, diet scotch will be withdrawn.Once consumer preferences are known, the product will be subject to an average degree ofrisk, and, therefore, McGregor requires a return of 12% on its investment. However, the initialtest-market phase is viewed as much riskier, and McGregor demands a return of 40% on thisinitial expenditure.What is the NPV of the diet scotch project?Question 12. Consider the following table. What would be the nine countries’ betas be if the correlation coef?cient for each was 0.5? Dothe calculation and explain.4 Question 13. Consider the beta estimates for the country indexes shown in the previous table.Could this information be helpful to a U.S. company considering capital investment projectsin these countries? Would a German company ?nd this information useful? ExplainQuestion 14. Suppose you are valuing a future stream of high-risk (high-beta) cash out?ows.High risk means a high discount rate. But the higher the discount rate, the less the presentvalue. This seems to say that the higher the risk of cash out?ows, the less you should worryabout them! Can that be right? Should the sign of the cash ?ow affect the appropriatediscount rate? Explain.Question 15. An oil company executive is considering investing $10 million in one or bothof two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 isexpected to produce $2 million for 15 years. These are real (in?ation-adjusted) cash ?ows.The beta for producing wells is 0.9. The market risk premium is 8%, the nominal risk-freeinterest rate is 6%, and expected in?ation is 4%.The two wells are intended to develop a previously discovered oil ?eld. Unfortunately there isstill a 20% chance of a dry hole in each case. A dry hole means zero cash ?ows and a completeloss of the $10 million investment.Ignore taxes and make further assumptions as necessary.(a) What is the correct real discount rate for cash ?ows from developed wells?(b) The oil company executive proposes to add 20 percentage points to the real discountrate to offset the risk of a dry hole. Calculate the NPV of each well this this adjusteddiscount rate.(c) What are the NPVs of the two wells?(d) Is there any single fudge factor that could be added to the discount rate for developedwells that would yield the correct NPV for both wells? Explain. 5