Lee Inc. purchases a digital color printer for $280,000 to launch its 5-year publishing project.
(11%) This printer will be fully depreciated by the straight-line method over its 7-year economic life, and will be sold for $60,000 at the termination of the 5-year project. The variable costs are $26 per copy, and annual fixed costs are $80,000. The unit selling price of the book is $32. The marginal tax rate is 35%, the inflation rate is 3%, and the discount rate is 14%. This project requires an initial net working capital requirement of $50,000 that can be fully recovered at the termination of the project.
(a) Compute the annual operating cash flow for this 5-year publishing project to break even in valuation, i.e., OCFBE.
(b) Use your answer for OCFBE in part (a) to compute the minimum number of copies needed to be sold annually for this 5-year publishing project to break even in valuation.
2. Lee Corp. is expected to experience a transitory turnaround period during which its
(12%) dividends are expected to cut the current amount of $1.50 by 40% next year, and to grow at 35% and 25%, respectively, in the following year two years. Afterwards, its dividends will experience sustainable growth indefinitely at an annual rate that reflects a 45% dividend payout ratio and a ROE of 18%. The discount rate is 14%.
(a) Compute the intrinsic value of Lee Corp's stock today. If the stock price for Lee Corp. is $32.50 today, what is your recommendation on this stock according to the intrinsic value analysis? Why? Be concise!
(b) Compute the value of income component and the value of growth component (NPVGO) of Lee Corp's stock at the END of its abnormal growth horizon.
3. In financing its $200M project, Lee Corp. issues $20M par value of preferred stocks,
(19%) $75M par value of long-term debt, and finances the balance with common stocks that have a stock beta of 1.25. Its 10-year bonds, which have a 7% coupon rate, are priced at an 8% discount from the par value. Its preferred stocks have a 6% annual dividend rate on a par value of $50, and are priced at $55 per share. Assume that the capital market is pricing all financial securities at their respective fair values, and the risk-free rate and the market rate of return, respectively, 2% and 15%.
(a) Compute the weighted average cost of capital (WACC), which is based on the market values of financial securities issued, for Lee Corp. assuming that the marginal corporate tax rate is 35%.
(b) The flotation costs for raising new debt capital, preferred stock capital and equity capital are, respectively, 3%, 6% and 18%. Besides, this $200M project is expected to generate a NPV of $18M. Compute the weighted average flotation cost, and the adjusted NPV of this project after taking into account of the flotation costs.
4. Consider the following municipal bond quotes:
(8%) Issue Coupon Maturity Price Yield
Nebraska Public Power District 5.00 2-1-2028 97? 5.20
(a) Compute the total amount that you paid for the purchase of $40,000 par value of this municipal bond on April 17, 2015? Assume 30-day month and 360-day year in your accrued interest computation.
(b) For an investor whose average and marginal tax rates are 28% and 33%, respectively, should s/he invest in the municipal bond in part (a) OR a corporate bond that is currently priced to yield 7.35%? Justify your choice quantitatively!
5. Given the following probability distributions for Stocks A and B, and the market portfolio, M:
(14%) State Probability Return on A Return on B Return on M
Bust 0.15 -0.25 0.00 -0.12
Normal 0.50 0.12 0.06 0.08
Boom 0.35 0.20 0.10 0.16
You construct a 2-stock portfolio by investing $9,000 in Stock A and $6,000 in Stock B.
(a) Compute the expected rate of return, beta, and standard deviation of the 2-stock portfolio, given that Stock A has a beta of 1.61 and Stock B has a beta of 0.36.
(b) Compute the required (CAPM) rate of return on the 2-stock portfolio, and explain your investment recommendation on this 2-stock portfolio according to the CAPM analysis, given that the risk-free rate and the inflation rate are, respectively, 0.015 and 0.020.
6. You are given the following information on the best guess of related outcomes for a
(10%) project. The initial cash outlay of a 3-year pilot study of the product is $12M, which represents the only cash flow associated with the pilot study. Following the pilot study, the company will spend an additional $72M to put the productive capabilities in place at t=3. If the study is successful, which is expected to have a probability of 0.70, the expected annual cash flows will be $30M during the 5-year production period. If the study fails, the expected annual cash flows will be $15M for five years. The applicable discount rate is 14% during the production period, and 12% during the pilot study period.
(a) Compute the NPV of this project (at t=0) assuming that the project will be implemented regardless of the outcome of the pilot study. To save your calculation, you are given that the value, at t=3, of the 5-year $30M annuity is $103.0M, and that of the 5-year $15M annuity is $51.5M.
(b) Now, you are given the option to upgrade by building a better production facility at t=3 for $90M if the pilot study fails, but stays with the original plan at t=3 if the study is successful. The upgraded facility is expected to generate annual cash flows of $25M for five years. Compute the PV (at t=0) of the option to upgrade.
(c) Would this option to upgrade change your recommendation on this project? Why?