1. Cyclone Wind Energy manufactures wind turbines used in the production of electric power. The firm is experiencing financial difficulty due to the recent development of competing sources of energy in the form of extensive shale oil production capacity that is profitable at a $40 per barrel price for West Texas Intermediate crude. The associated supply-related decline in the price of energy has reduced demand for Cyclone's wind turbines, causing the value of Cyclone's outstanding issue of zero coupon bonds that mature in exactly one year to drop to $891.78. In the event of a default, bondholders can expect to recover 30 percent of the bond's par value of $1000. The annual risk-free rate of interest is 3.5 percent. Assuming that all interest rates are compounded annually, and that investors value risky bonds by discounting the expected payoff at the risk-free interest rate:
a. determine the promised yield to maturity for Cyclone's outstanding zero-coupon bonds having one year to maturity,
b. estimate the probability that Cyclone will default on the firm's outstanding issue of zero coupon bonds maturing in one year.
2. The annualized yield to maturity for a zero-coupon U.S. Treasury strip having one year to maturity is currently 1.5 percent. The annualized yield to maturity for a zero-coupon U.S. Treasury strip having two years to maturity is 4.25 percent. Determine the:
a. forward rate of interest for a one-year period that begins in one year,
b. price of a two-year bond with a par value of $1000 making annual coupon payments based on a coupon rate of 10 percent (be sure to assume there is one coupon payment per year for the full amount of the yearly coupon interest on the bond) . (5 points) c. yield to maturity for the two-year bond with a 10 percent annual coupon rate.
3. Scissortail Property Management is evaluating a proposal to purchase two recently closed JC Penney stores located near Wichita, Kansas. The combined cost of purchasing these properties would be $5.5 million. One facility is a free standing one-story location having 25,000 square feet of floor space, while the other facility is located in a shopping mall in a growing part of Wichita, having two stories and 30,000 feet of floor space. The firm plans to convert these facilities respectively into a bowling alley and a family style Italian restaurant, requiring immediate conversion costs of $1.5 million dollars. The total time required to upgrade and resell both properties is expected to be three years. The CFO for Scissortail projects that at the end of the first year (date 1) the first facility can be sold for $5 million. The second facility, for which conversion and renovation will be more complicated and for which sale at an attractive price requires additional growth in the Wichita economy, will take three years to sell (at date 3), with an expected selling price of $4.5 million. Revisions to the tax code designed to help stimulate the economy exempt any profits from renovating and converting idle retail space from all State and Federal taxes. Assuming that the date 1 cash flows from the project can be reinvested at an annual rate of 2.25 percent:
a. determine the internal rate of return for the project.
b. determine the reinvested rate of return for the project.
c. concisely explain why the reinvested rate of return is less than or greater than the internal rate of return for the project (No points will be awarded for a simple comparison of the internal rate of return and the reinvested rate of return).
4. Quincy Durant is evaluating the terms for a 30-year loan for $300,000 that would enable him to purchase a new home. The bank is quoting a 4.8 percent interest rate on the mortgage and has agreed to set Mr. Durant's monthly mortgage payment at $1000.00 for the first five years of the loan term. At the end of the fifth year (after 60 monthly payments of $1000.00), the monthly loan payment will be reset so that the new monthly payment will pay off the outstanding loan balance over the remaining 25-year loan term. Assuming the interest rate on the loan is fixed for the entire 30-year loan term, determine:
a. the required monthly payment during the final 25 years of the loan term.
b. the outstanding balance of the loan at the end of year five, when the monthly payment on the loan is reset.
5. You have been retained by Talequah Milling Inc. (TMI) to review a contract proposal to produce sandbags for the Illinois River Authority (IRA) to reinforce the levees along the lower Illinois River. The contract calls for TMI to supply sandbags to IRA for a period of 5 years, generating yearly sales revenue of $500,000 per year. TMI's variable costs of production will be 60 percent ($0.60 per $1) of sales. While the production of sandbags will require no inventories, past experience with the IRA suggests the receivables turnover for the project will be 8 times per year. A regional economic development initiative would enable TMI to utilize an idle manufacturing facility located in Pouteau, Oklahoma at zero cost, with the facility reverting to the city at the end of the contract. Additionally, TMI would need to purchase two industrial-strength stitching machines. The stitching equipment can be purchased at a total cost of $300,000. The stitching equipment has a useful life of 5 years, with zero salvage value at the end of 5 years. The IRS allows the stitching equipment to be fully depreciated over a 4-year life using straight-line depreciation. Assuming that TMI has a tax rate of 30 percent and a required return of 11 percent, determine the maximum value of the proposed contract to PMI and make a recommendation as to whether or not the firm should agree to produce sandbags for the IRA.
6. Caddo Carrier is evaluating the length of the operating cycle over which trucks used in the firm's operations should be operated prior to replacement. Caddo has just purchased a new Peterbilt 389 with a 40,000-pound rear axle for $168,000. The '389' has a Cummins X15 565 horsepower engine, with an 18-speed transmission and a Pittsburgh Power Performance Computer. Recent changes to the tax code allow heavy trucks to be depreciated to a zero salvage value over 4 years using straight-line depreciation. Assuming a constant price for diesel fuel, the before-tax fuel costs required to travel the 120,000 miles the truck must cover each year will be $45,000 during year 1, $48,000 during year 2 and $54,000 during year 3. The before-tax maintenance costs for the '389' will be $10,000 during the 1st year, $17,500 during the 2nd year, and $20,000 during 3rd year. After-tax resale value would be $100,000 at the end of the 1st year, $60,000 at the end of the 2nd year and $35,000 at the end of the 3rd year (when ICC regulations require replacement of any truck that has been in service for at least 3 years). Caddo Carrier has a required return of 10 percent and a marginal tax rate of 35 percent. Assuming the Peterbilt 389 will be used on a continuing basis and that all costs will remain constant, determine the replacement policy that minimizes the total yearly cost of owning and operating a Peterbilt 389 over an extended time period.