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principles corporate finance
Corporate Finance 6th International Edition Stephen Ross, Randolph Westerfield, Jeffrey Jaffe - Solutions
10.12 A broker has advised you not to invest in oil industry stocks because, in her opinion, they are far too risky. She has shown you evidence of how wildly the prices of oil stocks have fluctuated in the recent past. She demonstrated that the standard deviation of oil stocks is very high relative
10.6 Suppose the expected returns and standard deviations of stocks A and B are respectively.a. Calculate the expected return and standard deviation of a portfolio that is composed of 40 percent A and 60 percent B when the correlation coefficient between the stocks is 0.5.b. Calculate the standard
• What are the differences between the capital market line and the security market line?
• What is the capital-asset-pricing model?
• Why is the SML a straight line?
• Why is beta the appropriate measure of risk for a single security in a large portfolio?
• What is the formula for beta?
• If all investors have homogeneous expectations, what portfolio of risky assets do they hold?
2. What sort of investor rationally views the beta of a security as the security’s proper measure of risk?
1. What sort of investor rationally views the variance (or standard deviation) of an individual security’s return as the security’s proper measure of risk?
• How does one determine the optimal portfolio among the efficient set of risky assets?
• What is the formula for the standard deviation of a portfolio composed of one riskless and one risky asset?
• Why doesn’t diversification eliminate all risk?
• What are the two components of the total risk of a security?
• How can the formula be expressed in terms of a box or matrix?
• What is the formula for the variance of a portfolio for many assets?
• What is the relationship between the shape of the efficient set for two assets and the correlation between the two assets?
• What are the highest and lowest possible values for the correlation coefficient?
• What is the diversification effect?
• What are the formulas for the expected return, variance, and standard deviation of a portfolio of two assets?
1. We have already determined the expected returns and standard deviations for both Supertech and Slowpoke. (The expected returns are 0.175 and 0.055 for Supertech and Slowpoke, respectively. The standard deviations are 0.2586 and 0.1150, respectively.)In addition, we calculated the deviation of
9.20 The returns on the market of common stocks and on Treasury bills are contingent on the economy as follows.a. Calculate the expected returns on the market and Treasury bills.b. Calculate the expected risk premium. Economic Condition Probability Market Return Treasury Bills Recession 0.25 -8.2%
9.18 Ibbotson and Sinquefield have reported the returns on small-company stocks and U.S.Treasury bills for the period 1986–1991 as follows.a. Calculate the average returns on small-company stocks and U.S. Treasury bills.b. Calculate the variances and standard deviations of the returns on
9.17 The following data are the returns for 1980 through 1986 on five types of capital-market instruments: common stocks, small-capitalization stocks, long-term corporate bonds, longterm U.S. government bonds, and U.S. Treasury bills.Calculate the average return and variance for each type of
9.16 The returns on the small-company stocks and on the S&P composite index of common stocks from 1935 through 1939 are tabulated below.a. Calculate the average return for the small-company stocks and the market index of common stocks.b. Calculate the variance and standard deviation of returns
9.15 Four equally likely states of the economy may prevail next year. Below are the returns on the stocks of P and Q companies under each of the possible states.a. What is the expected return on each stock?b. What is the variance of the returns of each stock? State P Stock Q Stock 1234 0.04 0.05 2
9.14 The returns on the market and on Trebli stock are shown below for the five possible states of the economy that might prevail next year.a. What is the expected return on the market?b. What is the expected return on Trebli stock? Market Trebli Economic Condition Probability Return Return Rapid
9.11 The following are the returns during the past seven years on a market portfolio of common stocks and on Treasury bills.The realized risk premium is the return on the common stocks less the return on the Treasury bills.a. Calculate the realized risk premium of common stocks over T-bills in each
9.10 During the past seven years, the returns on a portfolio of long-term corporate bonds were the followinga. Calculate the average return for long-term corporate bonds over this period.b. Calculate the variance and the standard deviation of the returns for long-term corporate bonds during this
9.8 S&P 500 index returns of common stocks for the period 1981–1985 are as follows.Calculate the five-year holding-period return. 1981 1982 1983 1984 1985 S&P 500 index return (%) -4.91 21.41 22.51 6.27 32.16
1. Suppose a stock begins the year with a price of $25 per share and ends with a price of $35 per share. During the year it paid a $2 dividend per share. What are its dividend yield, its capital gain, and its total return for the year? We can imagine the cash flows in Figure 9.3. FIGURE 9.3 Cash
8.14 Allied Products is thinking about a new product launch. The vice president of marketing suggests that Allied Products can sell 2 million units per year at $100 net cash flow per unit for the next 10 years. Allied Products uses a 20-percent discount rate for new product launches and the
8.13 You have been hired as a financial analyst to do a feasibility study of a new video game for Passivision. Marketing research suggests Passivision can sell 12,000 units per year at$62.50 net cash flow per unit for the next 10 years. Total annual operating cash flow is forecasted to be $62.50 *
8.7 Using the information in the problem above, what is the present value break-even point if the discount rate is 15 percent, initial investment is $140,000, and the life of the project is seven years? Assume a straight-line depreciation method with a zero salvage value.
8.6 You are considering investing in a fledgling company that cultivates abalone for sale to local restaurants. The proprietor says he’ll return all profits to you after covering operating costs and his salary. How many abalone must be harvested and sold in the first year of operations for you to
8.5 What is the minimum number of units that a distributor of big-screen TVs must sell in a given period to break even? Sales price Variable costs $1,500 = $1,100 Fixed costs $120,000 Depreciation $20,000 Tax rate = 35%
• Describe how sensitivity analysis interacts with break-even analysis.
• What is a break-even analysis?
• Why is it important to perform a sensitivity analysis?
• How can managers use the market to help them screen out negative NPV projects?
• What are the ways a firm can create positive NPV projects?
9.19 Suppose International Trading Company’s stock returns follow a normal distribution with a mean of 17.5 percent and a standard deviation of 8.5 percent. What is the range of returns in which about 95 percent of International Trading’s stock returns are located?
9.13 The probability that the economy will experience moderate growth next year is 0.4. The probability of a recession is 0.3, and the probability of a rapid expansion is also 0.3. If the economy falls into a recession, you can expect to receive a return on your portfolio of 2 percent. With
9.12 The probability that the economy will experience moderate growth next year is 0.6. The probability of a recession is 0.2, and the probability of a rapid expansion is also 0.2. If the economy falls into a recession, you can expect to receive a return on your portfolio of 5 percent. With
9.9 The Wall Street Journal announced yesterday that the current rate for one-year Treasury bills is 4.36 percent, while an Ibbotson and Sinquefield study shows that the average return on Treasury bills for the period 1926–1997 is 3.8 percent. During the same period the average return on
9.7 Two stocks, Koke and Pepsee, had the same prices two years ago. During the last two years, Koke’s stock price had first increased by 10 percent and then dropped by 10 percent, while Pepsee’s stock price had first dropped by 10 percent and then increased by 10 percent. Do these two stocks
• What does the observation tell us about investors for the period from 1926 through 1999?
• What is the major observation about capital markets that we will seek to explain?
• What is the longest period of time such that if you had invested at the beginning of the period, you would still not have had a positive return on your common-stock investment by the end?
• For common stocks, what is the longest period of time without a single losing year? What is the longest streak of losing years?
• In how many years did the common-stock return exceed 30 percent, and in how many years was it below 20 percent?
• What is the largest one-period return in the 74-year history of common stocks we have displayed, and when did it occur? What is the smallest return, and when did it occur?
• What is the difference between a dollar return and a percentage return?
6.20 The Utah Mining Corporation is set to open a gold mine near Provo, Utah. According to the treasurer, Steven Sample, “This is a golden opportunity.” The mine will cost $600,000 to open. It will generate a cash inflow of $100,000 during the first year and the cash flows are projected to grow
6.17 Define each of the following investment rules. In your definition state the criteria for accepting or rejecting an investment under each rule.a. Payback periodb. Average accounting returnc. Internal rate of returnd. Profitability indexe. Net present value
6.16 Bill plans to open a self-serve grooming center in a storefront. The grooming equipment will cost $160,000. Bill expects the after-tax cash inflows to be $40,000 annually for seven years, after which he plans to scrap the equipment and retire to the beaches of Jamaica.Assume the required
6.12 Project A involves an investment of $1 million, and project B involves an investment of$2 million. Both projects have a unique internal rate of return of 20 percent. Is the following statement true or false? Explain your answer.For any discount rate between 0 percent and 20 percent, inclusive,
6.11 Consider two streams of cash flows, A and B. Cash flow A consists of $5,000 starting three years from today and growing at 4 percent in perpetuity. Cash flow B consists of $6,000 starting two years from today and continuing in perpetuity. Assume the appropriate discount rate is 12 percent.a.
6.5 Nokia Group has invested $8,000 in a high-tech project. This cost is depreciated on an accelerated basis that yields $4,000, $2,500, $1,500 of depreciation, respectively, during its three-year economic life. The project is expected to produce income before tax of $2,000 each year during its
6.4 Western Printing Co. has an opportunity to purchase a $2 million new printing machine. It has an economic life of five years and will be worthless after that time. This new investment is expected to generate an annual net income of $100,000 one year from today and the income stream will grow at
6.2 Suppose Peach Paving Company invests $1 million today on a new construction project.The project will generate annual cash flows of $150,000 in perpetuity. The appropriate annual discount rate for the project is 10 percent.a. What is the payback period for the project? If the Peach Paving
• How is the profitability index applied to independent projects, mutually exclusive projects, and situations of capital rationing?
• How does one calculate a project’s profitability index?
• What are two additional problems applying only to mutually exclusive projects?
• What are two problems with the IRR approach that apply to both independent and mutually exclusive projects?
• What is the difference between independent projects and mutually exclusive projects?
• What are some flaws with the AAR approach?
• What are the three steps in calculating AAR?
• What are some advantages of Payback Period Rule ?
• List the problems of the payback period rule.
7.35 (Challenge) A firm considers an investment of $28,000,000 (purchase price) in new equipment to replace old equipment that has a book value of $12,000,000 (market value of$20,000,000). If the firm replaces the old equipment with the new equipment, it expects to save $17,500,000 in pretax cash
7.33 Kaul Construction must choose between two pieces of equipment. Tamper A costs$600,000 and it will last five years. This tamper will require $110,000 of maintenance each year. Tamper B costs $750,000, but it will last seven years. Maintenance costs for Tamper B are $90,000 per year. Kaul incurs
7.32 Station WJXT is considering the replacement of its old, fully depreciated sound mixer.Two new models are available. Mixer X has a cost of $400,000, a five-year expected life, and after-tax cash flow savings of $120,000 per year. Mixer Y has a cost of $600,000, an eight-year life, and after-tax
7.31 BYO University is faced with the decision of which word processor to purchase for its typing pool. It can buy 10 Bang word processors which cost $8,000 each and have estimated annual, year-end maintenance costs of $2,000 per machine. The Bang word processors will be replaced at the end of year
7.30 Gold Star Industries is in need of computers. They have narrowed the choices to the SAL 5000 and the DET 1000. They would need 10 SALs. Each SAL costs $3,750 and requires$500 of maintenance each year. At the end of the computer’s eight-year life Gold Star expects to be able to sell each one
7.28 Fiber Glasses must choose between two kinds of facilities. Facility I costs $2.1 million and its economic life is seven years. The maintenance costs for facility I are $60,000 per year.Facility II costs $2.8 million and it lasts 10 years. The annual maintenance costs for facility II are
7.26 Aviara Golf Academy is evaluating different golf practice equipment. The “easy as pie”equipment costs $45,000, has a three-year life, and costs $5,000 per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation down to zero is used.
7.25 United Healthcare, Inc. needs a new admitting system, which costs $60,000 and requires$2,000 in maintenance for each year of its five-year life. The system will be depreciated straight-line down to zero without salvage value at the end of five years. Assume a tax rate of 35 percent and an
7.24 A machine costs $60,000 and requires $5,000 maintenance for each year of its three-year life. After three years, this machine will be replaced. Assume a tax rate of 34 percent and a discount rate of 14 percent. If the machine is depreciated with a three-year straight-line without a salvage
7.22 After extensive medical and marketing research, Pill, Inc., believes it can penetrate the pain reliever market. It can follow one of two strategies. The first is to manufacture a medication aimed at relieving headache pain. The second strategy is to make a pill designed to relieve headache and
7.21 Majestic Mining Company (MMC) is negotiating for the purchase of a new piece of equipment for their current operations. MMC wants to know the maximum price that it should be willing to pay for the equipment. That is, how high must the price be for the equipment to have an NPV of zero? You are
7.20 International Buckeyes is building a factory that can make 1 million buckeyes a year for five years. The factory costs $6 million. In year 1, each buckeye will sell for $3.15 in nominal terms. The price will rise 5 percent each year in real terms. During the first year variable costs will be
7.19 Sparkling Water, Inc., sells 2 million bottles of drinking water each year. Each bottle sells at $2.5 in real terms and costs per bottle are $0.7 in real terms. Sales income and costs occur at year-end. Sales income is expected to rise at a real rate of 7 percent annually, while real costs are
7.15 Phillips Industries runs a small manufacturing operation. For this year, it expects to have real net cash flows of $120,000. Phillips is an ongoing operation, but it expects competitive pressures to erode its (inflation-adjusted) net cash flows at 6 percent per year.The appropriate real
7.14 Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $120,000. The facility is to be depreciated on a seven-year basis. It is expected to have no value after seven years. Operating revenues from the facility are expected to be$50,000 in the first
7.12 Royal Dutch Petroleum is considering going into a new project, which is typical for the firm. A capital tool required for the project costs $2 million. The marketing department predicts that sales will be $1.2 million per year for the next four years, after which the market will cease to
7.11 Commercial Real Estate, Inc., is considering the purchase of a $4 million building to lease.The economic life of the building will be 20 years. Assume that the building will be fully depreciated by the straight-line method and its market value in 20 years will be zero. The company expects that
7.10 Etonic Inc. is considering an investment of $250,000 in an asset with an economic life of five years. The firm estimates that the nominal annual cash revenues and expenses will be$200,000 and $50,000, respectively. Both revenues and expenses are expected to grow at 3 percent per year as that
7.9 The Gap is considering buying an on-line cash register software from IBM so that it can effectively deal with its retail sales. The software package costs $750,000 and will be depreciated down to zero using the straight-line method over its five-year economic life. The marketing department
7.8 Scott Investors, Inc., is considering the purchase of a $500,000 computer that has an economic life of five years. The computer will be depreciated based on the system enacted by the Tax Reform Act of 1986. (See Table 7.3 for the depreciation schedules.) The market value of the computer will be
7.7 Dickinson Brothers, Inc., is considering investing in a machine to produce computer keyboards. The price of the machine will be $400,000 and its economic life five years. The machine will be fully depreciated by the straight-line method. The machine will produce 10,000 units of keyboards each
7.6 Samsung International has rice fields in California that are expected to produce average annual profits of $800,000 in real terms forever. Samsung has no depreciable assets and is an all-equity firm with 200,000 shares outstanding. The appropriate discount rate for its stock is 12 percent.
7.4 According to the February 7, 1983, issue of The Sporting News, the Kansas City Royals’designated hitter, Hal McRae, signed a three-year contract in January 1983 with the following provisions:• $400,000 signing bonus.• $250,000 salary per year for three years.• 10 years of deferred
7.2 Your company currently produces and sells steel-shaft golf clubs. The Board of Directors wants you to look at introducing a new line of titanium bubble woods with graphite shaft.Which of the following costs are not relevant?I. Land you already own that will be used for the project and has a
7.1 Which of the following cash flows should be treated as incremental cash flows when computing the NPV of an investment?a. The reduction in the sales of the company’s other products.b. The expenditure on plant and equipment.c. The cost of research and development undertaken in connection with
• Can you list the assumptions that we must make to use EAC?
• What is the equivalent annual cost method of capital budgeting?
1. EOBII Publishers, a competitor of Burrows, recently bought a printing press for$2,000,000 to be depreciated by the straight-line method over five years. This implies yearly depreciation of $400,000 ($2,000,000/5). Is this $400,000 figure a real or nominal quantity?
• Why is working capital viewed as a cash outflow?
• Why did we determine income when NPV analysis discounts cash flows, not income?
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