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ACTSC 372 - Assignment #4 Due Tuesday December 1 at noon in the drop boxes Question 1: Consider a project with that has the following characteristics Initial cost is $12 million, and the project will earn $1.75 million in EBIT in perpetuity. Assume the corporate tax rate is 20%. Ignore personal taxes and costs associated with financial distress. The returns on debt are 6% and the return on unlevered equity is 10%. Assume the company plans to issue $6 million in debt to finance the project. Should we invest? Use the APV and WACC methods (HINT: find them in that order) Question 2: Tim Horton's is considering a project to make jumbo jets. Should Tim's undertake the project? The following data may be useful. Tim's has a target D/E of 0.6. Tim's current beta is 1.1. Boeing has a D/E of 1.2 and a beta of 2.1. Assume the risk free rate is 4% and the market risk premium is 6%. The project will cost $1 billion, and will generate EBITDA of $175 million. Assume the entire project cost will consist of assets which will be eligible for CCA with a CCA rate of 20%. Assume the project will run indefinitely. Tim's planning to finance this project at the same D/E level that the company currently enjoys, and assume that Tim's can borrow at 4.5%. Boeing's borrowing rate is 7%. All firms pay tax at a rate of 25%. Question 3: In this question, we will explore the irrelevance of dividend policy. Suppose XYZ Inc currently has 1 million shares outstanding, and XYZ expects to make $1 million per year in perpetuity, all of which is paid out in dividends. Assume the relevant discount rate is 10%. (Ignore taxes and transaction costs, and assume the markets are efficient.) a. What is the value of one share of XYZ Inc? (Assume the next dividend payment is one year from today.) b. Now assume XYZ Inc plans to change its dividend policy as follows: the company will skip the next dividend payment and instead it will repurchase $1 million worth of shares. In year 2, and in all subsequent years, the dividends will resume and all the income will be paid out as dividends. What is the current share price under this policy? Provide an explicit calculation of the share price given the new dividend payment stream. (Hint: Let P1 be the share price at time 1, immediately before the share repurchase. Calculate the number of shares repurchased, and then find the dividends per share for years 2 and beyond. Discount all this back in order to find the current share price.) Do not assume the M&M proposition that the dividend policy is irrelevant. Essentially, this question is meant to prove that fact. c. Suppose you purchase 100 shares today, and sell them 2 years from now, immediately after the year 2 dividend is paid. What is your total profit under each dividend policy? Does this difference in profit violate the indifference of dividend policy? Explain. Question 4: In this question, we will explore the significance of the risk coefficients on decision making. a. Find all utility functions such that () = , where is a constant. b. Find all utility functions such that () = , where is a constant. c. Assume your utility function satisfies part a. Assume you are faced with a loss of $1000 with probability , and no loss with probability 1 . Prove that the amount you are willing to spend to insure against this loss is independent of your current wealth. (This essentially proves that people who have a constant absolute risk aversion coefficient view losses (expressed in absolute terms) identically, regardless of wealth level.) d. Now assume your utility function satisfies part b. Assume you are faced with a loss of 10% of your current wealth with probability and no loss with probability 1 . Show that the amount you are willing to spend to insure against this loss (expressed as a percentage of your current wealth) is constant (i.e. it is independent of your current wealth level). (This shows that people who have a constant relative risk aversion coefficient view losses (expressed in relative terms) identically, regardless of wealth level.) HINT: for parts a and b, you may find the following basic calculus fact helpful: For a function (), the Chain Rule shows (ln ) =