Problem 1
Arbitrage Financial is offering two possible investments with the same level of risk. Investment #1 is a perpetuity, with the first cash flow (of $100 per year) coming in one year. Investment #2 is also a perpetuity (paying $100 per year), but its first cash flow occurs in two years.
(a) Which investment is more valuable today? Why?
(b) Suppose that the difference in today's prices of Investment #1 and Investment #2 is $93.46. What discount rate are investors using to value the investments? Support your answer with calculations.
Discount rate = ??
Problem 2
The Bravo Company just paid an annual dividend of $4.00 per share. Due to a need to conserve cash, the dividend in one year will be cut to zero. Dividends per share are forecasted to be $1.50 in two years, $2.50 in three years, and $3.50 in four years. After four years, dividends are expected to grow at a constant rate forever. Investors in Bravo Company require a return of 12%. The current market price of Bravo's stock is $30.66 per share.
Determine the constant growth rate in dividends after four years that would justify the current market price.
Growth rate = ??
Problem 3
Consider the financial statements below:
|
Mercury Inc. 2011 Income Statement
|
|
Sales
|
12,000
|
|
COGS
|
(7,000)
|
|
Gross Profit
|
5,000
|
|
SG&A
|
(1,000)
|
|
Operating income
|
4,000
|
|
Interest expense
|
(500)
|
|
Taxable income
|
3,500
|
|
Taxes (40%)
|
(1,400)
|
|
Net Income
|
2,100
|
|
Dividends
|
840
|
|
Mercury Inc. 2011 Balance Sheet
|
|
|
Cash
|
2,000
|
|
A/P
|
1,000
|
|
A/R
|
3,000
|
|
Notes payable
|
1,000
|
|
Inventory
|
4,000
|
|
Total current liabilities
|
2,000
|
|
Total current assets
|
9,000
|
|
|
|
|
|
|
|
Long-term debt
|
5,000
|
|
|
|
|
|
|
|
|
|
|
Common stock
|
3,000
|
|
Fixed assets
|
7,000
|
|
Retained earnings
|
6,000
|
|
|
|
|
Total equity
|
9,000
|
|
Total
|
16,000
|
|
Total
|
16,000
|
| |
|
|
|
|
|
(a) Compute the return on invested capital for 2011.
ROIC = ??
(b) Suppose the company plans to issue another $2,000 in debt and use the proceeds to repurchase stock. The overall size of the company and the nature of its business will not change. Will the ROIC increase, decrease, or stay the same? Explain.
Problem 4
Universal Investments offers an annuity that pays $500 per year for ten years, with the first cash flow coming one year from today. The relevant discount rate is 6% for the first five years. After five years, the rate will drop to 4% and remain at that level. How much would you pay for this annuity today?