Question 1. AMAX Corporation is a mining company that focuses on extraction of molybdenum-a crucial additive in the production of steel. AMAX is considering expanding its molybdenum capacity and is deciding whether to pursue one of the following investment alternatives:
a) An investment to expand capacity at its Climax mine would cost $100M today (year 0), $50M next year (year 1) and would increase capacity in years 3 to 9 by 15M pounds (note there is no cash flow in year 2). The variable cost of extracting molybdenum at this location would be $4/pound. [Hint: nominal annual profits from the increased capacity would therefore be given by 15M x (P - $4), where P is the price of molybdenum]
b) An investment to expand capacity at its Henderson mine would cost $75M today (year 0), $30M next year (year 1) and would increase capacity by 13M pound per year from years 3 to 9. The variable costs of extracting molybdenum from this location would be $4.5/pound.
c) Reopening of its Kitsault mine would require an investment of $25M today (year 0), $10M in year 1 and $10M in year 2 and would increase capacity in years 3 to 9 by 10M pounds. The variable cost of extraction would be $6/pound. If the discount rate is 16%, find the price of molybdenum above which it makes sense to do each of the investments a), b), and c).
Question 2. A bond with 5 years to maturity, a face value of $1,000 and a coupon rate of 9.0% is selling for $950. What is its yield to maturity? If the yield changes to 9.0%, what will happen to the price of the bond? (Assume annual coupon payments.)
Question 3. Next year, NPI expects net income of $16 million. It plans to reinvest 50% of its earnings and pay out the rest as dividends. NPI will continue this policy into the indefinite future. Its cost of equity capital is 12%. If NPI earns a 16% rate of return on the funds reinvested, what is the growth rate and value of NPI's equity? Hypothetically, had the firm not reinvested any of its earnings and instead paid them out as dividends, what would have been the equity value? How much does reinvesting contribute to equity value?
Question 4. Suppose NPI's reinvestment rate of return on all future retained earnings were 12% instead of the 16% assumed in the previous problem. (Continue to assume initial earnings of $16 million.) a) What happens to the growth rate and the value of equity? Compute the growth rate and equity value if NPI reinvests b) 25% of earnings and c) 0% of earnings.
Question 5. You are the sole equity owner of A-team Inc your firm is expected to generate the following set of cash flows (000) in the future:
1 2 3 4 5
Year Cash Flow -----------------------------------------------------------------
140 150 180 220 285
The discount rate for these cash flows is 9%.
a) What is the present value of the cash flows that A-team Inc is expected to generate? Call this "The Value of the Firm".
In previous years your firm borrowed money to finance early stage investments. Currently ATeam Inc still has an outstanding debt of $300K that remains on it current balance sheet (i.e. at t=0). The debt contract you have signed commits the firm to pay to the bank the interest on the outstanding principal each year as well retire $100K in principal until the loan is fully repaid. All payments are made on the last day of each year and the interest is calculated on the remaining principal from the previous year1. The loan rate of interest is 9%.2
b) What are the cash flows that the debt holders will receive in each year? What is the present value of these cash flow (use 9% as the discount rate)?
c) Assume that all remaining cash flows (over above what is paid to the debt holders) are paid out as a dividend. What is the cash flow to equity holders each year?
d) What is the present value of the cash flow to equity holders? You should use the discount rate of 9% to value these although later in the semester we will learn how to adjust this discount rate to reflect the capital structure of the firm.
e) How does the sum of the value of debt (part b) and the value of equity (part d) compare to the value of the firm (part a)?
So for example, in year 1, the interest payment due is $300K×9%=$27K and the total payment to the bank is $100K+$27K=$127K.
Question 6. You are the sole equity owner of B-Team Inc. Currently your firm has no debt. Your firm is expected to generate the following set of cash flows ($000) in the future
1 2 3 4 5
Year Cash Flow -----------------------------------------------------------------
250 400 -150 600 780
The discount rate for these cash flows is 12%. Notice that in the third year cash flow is negative (-150) indicating that you expect B-Team Inc to undertake a large investment in that year.
a) Suppose first that you expect to pay for this investment in the third year yourself. All other positive cash flows will be paid out to you as a dividend. That is, you will get all positive cash flows and pay for all the costs. What is the present value of your B-Team's equity?
b) Suppose instead that B-Team Inc plans to finance the investment by borrowing $150K in the third year. The firm plans to repay this debt (both interest and principal) in the fourth year. For simplicity assume that the firm will borrow at 12%. What is the total payment that the firm will need to make to repay the loan in year 4?
c) Suppose that any surplus cash flows (i.e. over and above what is needed to pay the debt) will be paid out as a dividend to you in each year. What are the cash flows will you receive in each year?
d) What is the present value of your equity holdings under the scenario where the firm plans to borrow $150K in the third year? How does this differ from your answer to a)? How does your answer contrast with the answer in Question 5? Explain the difference.