1.Lucy has $900,000 to invest and she wants a portfolio beta of 1.2. The S&P 500 has an expected return of 18% and the standard deviation is 30%. The risk-free return is 5%. She plans to put her money in the S&P 500 and T-bills. What is the expected return (in %) and standard deviation of her portfolio?
2.AMS has 20% debt in its capital structure. Currently, the levered equity beta is 1 and the debt beta is 0. The T-bill rate is 4% and the expected return on the market is 14%. The firm plans to issue additional debt. The debt moves the firm to its target debt level of 30%. What is the new return on levered equity?
3.Brain Drain is about to launch a new product. Depending on the success of the new product, there are three possible outcomes for value next year: $210 million, $150 million or $60 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 5%. (Ignore all other market imperfections, such as taxes.). Brain Drain has $120 million in debt due next year.
a. What is Brain’s total value with leverage?
a. Now suppose that in the event of default, 30% of the value of Brain’s assets will be lost to bankruptcy costs. What is Brain’s total value with leverage and distress costs?
4.Grim Enterprises is considering a new product line that requires a new machine. It will cost $24,000,000. It will be fully depreciated to a zero book value on a straight line basis over 3 years. The project will generate $75,000,000 in sales each year for 3 years. Operating costs are 81% of sales per year for 3 years. Grim will have $800,000 annually in interest expense as part of the financing. The tax rate is 40%. Grim estimates the unlevered cost of capital as 14%. Note: Costs do not include depreciation or interest expense.
a. Find the base-case net present value (NPV).
b. Suppose the project will be financed with $10,000,000 in bonds. The bonds have a 3-year life, a coupon rate of 8% and a yield of 8%. The remaining funds will come from retained earnings. Find the adjusted present value (APV).
5.A project generates net (after-tax) cash flows of $20 million every year for 4 years. The investment is $43 million. The tax rate is 40%. The firm has a target debt ratio of 40%. Out of total equity, they will use $6,000,000 in preferred stock and the rest will be from retained earnings.
· The firm’s current bonds have 5 years left to maturity, a coupon rate of 7% with annual coupons, a face value of $1000 and currently trade for $960. The before-tax cost on any new bonds will be the same as the yield to maturity on the current bonds.
· Preferred stock has a dividend of $4 with a price of $42. Issue costs on preferred stock are $2.
· To estimate the cost of retained earnings, the firm uses a beta of 1.3 with a risk-free rate of 4% and a market risk premium of 10%.
Use the weighted average cost of capital (WACC) to find the net present value (NPV) of the project. For the WACC, carry work out to 4 decimal points.