Assignment:
Read the article ‘Telecom Italia cuts dividend as debt bites'.
Answer the following questions.
a. According to the dependence hypothesis of MM, a firm can enhance its total value by raising its debt-equity ratio. Discuss four potential
reasons why Telecom Italia decided to reduce its debt level.
b. ‘The cost of debt is, in general, lower than the cost of equity, so a company should always use debt financing in order to lower the company cost of capital.'
Question 2
Glenlivet Company is considering a new four-year project that complements its existing business. This project requires an initial fixed asset investment of $4,000,000. The fixed asset will be depreciated straight-line to zero over its four-year tax life, after which it will be worthless. The project is estimated to generate $2,800,000 in annual sales, with costs of $1,100,000. The company is an all-equity financed company and its cost of capital is 10%. The tax rate is 35%.
a. Evaluate whether Glenlivet Company should accept this new project.
b. If the new project's beta risk is not equal to that of the company, evaluate whether Glenlivet Company should accept the new project. Assume the beta risk of the new project is 1.5, the expected risk premium on the market is 10%, and risk free bonds are yielding 5%.
c. Discuss two consequences if Glenlivet Company always uses the weighted average cost of capital (WACC) to make decisions for all new projects.
Question 3
This question is modified from questions and problems 26-27 of our textbook (p. 231):
Consider a project to supply Detroit with 55,000 tons of machine screws annually for automobile production. You will need an initial $1,700,000 investment in threading equipment to get the project started; the project will last for five years. The accounting department estimates that annual fixed costs will be 520,000 and that variable costs should be $220 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the five-year project life. It also estimates a salvage value of $300,000 after dismantling costs.
The marketing department estimates that the automakers will let the contract at a selling price of $245 per ton. The engineering department estimates you will need an initial net working capital investment of $600,000. You require a 13% return and face a marginal tax rate of 38% on this project.
a. Determine the estimated operating cash flow (OCF) and net present value (NPV) for this project and discuss whether you should pursue this project.
b. Suppose you believe that the accounting department's initial cost and salvage value projections are accurate only to within ±15%; the marketing department's price estimate is accurate only to within 4 FIN B862 Finance for Corporations ±10%; and the engineering epartment's net working capital estimate is accurate only to within ±5%.
What is your worst-case scenario for this project? Your best-case scenario? Discuss whether you still want to pursue the project under each scenario.
c. Suppose you are confident about your own projections, but you are a little unsure about Detroit's actual machine screw requirements. What is the sensitivity of the project OCF to changes in the quantity supplied? What about the sensitivity of net present value to changes in the quantity supplied? Given the sensitivity number you calculated, is there some minimum level of output below which you wouldn't want to operate? Why?
Question 4
Answer the following questions on risk and return.
a. Explain whether a risky asset could have a zero beta or negative beta and discuss the expected return on such an asset.
b. Suppose Tencent Holdings Ltd has traded as low as HK$180 and as high as its current HK$355. Explain whether we can conclude that the stock of Tencent Holdings Ltd has a very high beta due to its large price movement.
c Suppose HSBC has an expected return of 15%, the risk-free rate is 3%, and the market risk premium is 10%. Determine the beta of the stock of HSBC.