problem 1: Melissa Tang has recently sold her stake in Global Manufacturing Ltd., a firm that she founded in 1990, for $15 million. She is now trying to decide how best to invest the proceeds to support her during her retirement. Following a preliminary conversation with her investment advisor, she is considering investing them in a portfolio consisting of one-year Government of Canada treasury bills, the bonds of Gardner Company, and the shares of Anderson Inc. Recognizing that taxes will represent a significant expense, she is interested in how they might differ between the two different types of investments, debt and equity. To this end, she has asked you to determine the taxes that she might reasonably expect to pay on the two investments recommended by the advisor.
As a first step, you have determined that Melissa’s marginal federal tax rate is 29% and her marginal provincial tax rate is 17%. You have also determined that the gross up on eligible dividends is 41%, the dividend tax credit is 16.44% of the grossed-up amount, and the provincial tax rate on eligible dividends is 11.5% of the actual dividend.
a) The shares of Anderson Inc. are currently selling for $2.50 and paid a dividend of $0.20 per share last year. The investment advisor has informed Melissa that these dividends should increase by 5% this year and that the shares should be trading at a price of $3.00 in one year’s time. Assuming that the investment advisor’s beliefs turn out to be true, what is the total tax that Melissa will have to pay if she invests $2,500 in the shares of Anderson today and sells them in one year’s time?
b) The bonds of Gardner Company are currently priced to yield 8%, carry a coupon rate of 6% payable semi-annually, and have 10 years remaining until maturity. Based on anticipated changes in interest rates, the advisor believes that the bonds will be selling for $95 in one year’s time. Assuming that the investment advisor’s beliefs turn out to be true, what is the total tax that Melissa will have to pay if she purchases 25 $100 face value bonds of Gardner Company today and sells them in one year’s time?
c) If Melissa decides to invest $4 million in one-year treasury bills that offer a 3% yield, $5 million in the bonds of Gardner Company and $6 million in the shares of Anderson Inc., what is the expected after-tax rate of return on her selected investment portfolio?
problem 2: A client of Investment Advisor Associates (IAA), Gillian Bissett, has recently won $5 million in the lottery and has asked for investment advice. She has indicated that she would like to have $5 million available for her retirement in 15 years and has therefore decided to invest $2 million in a secure account that is expected to provide an effective annual return of 4% over this period. She would then like to supplement her current income and add to the balance in the secure account by investing the remaining $3 million that she has won. Here, she has initially indicated that she would like to invest a part of the remaining amount in government bonds and the remainder in an equity fund highly recommended by IAA. As a part of their advice, she has asked IAA to provide her with details on the return and risk profiles of these two investments.
a) Assume that Gillian deposits $2 million into the secure account at 4%. How much must she additionally deposit into the account at the end of each year for the next 15 years to have the required $5 million at the end of the 15 years, assuming that she intends to deposit an equal amount each year?
b) The government bonds that Gillian is interested in investing in have 12-year maturity and a coupon rate of 6% paid semi-annually. These bonds are currently selling at $108 for each $100 face value bond. What is the yield to maturity on these bonds? What is their expected effective annual return?
c) The equity fund recommended by IAA has provided a dividend (current) yield of 4% over the past decade as well as providing a consistent capital gain. Gillian would like to know what the expected return on the equity fund is. To determine this, the following information is available:
• Expected return on the market = 10%
• Standard deviation of the market return = 12%
• Risk-free rate = 3.5%
• Standard deviation of return on the equity fund = 20%
• Correlation between the return on the equity fund and the market = 0.75
Based on this information, what is the expected return on the equity fund?
d) If the standard deviation of return for the bonds in part (b) is 8% and the correlation between their return and the return on equity fund in part (c) is 0.55, what is the standard deviation of return for a portfolio comprised of 35% bonds and 65% the equity fund?
e) Estimate the beta of this portfolio (35% bonds and 65% equity) and determine its required return according to the security market line (SML) based on the information supplied in parts (b), (c), and (d) above if the correlation coefficient between the bond returns and the market returns is 0.3.
f) Ignore your answers for parts (b) and (c), and alternatively assume that the expected effective annual return on the bond is 7% and the expected return on the equity fund is 12%. Also assume portfolio weights of 60% debt and 40% equity. Does the portfolio lie above or below the SML? (2 marks)
g) Independent of parts (a) to (f) above, Gillian is considering investing in a relatively new company whose profitability has been growing at a compound rate of 25% per year. Using the constant growth DDM (dividend discount model), she find outs that the share price should be $75; this is substantially more than the actual market price of the shares ($50). What is the most likely reason for the wide disparity between the observed price and that which Gillian estimates?
problem 3: You have been asked by Mogul-Basher (MB) Ltd., a manufacturer of snowboards, to evaluate its capital structure. As a first step, you need to estimate MB’s current weighted average cost of capital (WACC). You have been provided with the following information to complete this task.
MB currently has a $100 million face value long-term debt issue outstanding. The bonds have 4 years remaining until maturity, carry a 7% coupon, payable semi-annually, and have a current price of $105 per $100 face value bond. MB also has 5 million preferred shares outstanding. These shares are currently trading at $15 and carry a dividend of $1.25 per share. Finally, MB has 15 million common shares outstanding that are currently trading at $20. The beta on the common shares of MB is 1.10, the market price of risk is 6%, and the risk-free rate is 3%.
MB has been advised by its underpreparers that flotation costs would be 5% after-tax on new debt and 6% before-tax on preferred shares and common shares. MB’s marginal tax rate is 35%.
Required:
a) Determine the appropriate weights to use in determining MB’s WACC.
b) find out MB’s cost of debt, cost of preferred shares, cost of internal equity, and cost of issuing new common equity.
c) Based on your calculations in parts (a) and (b), estimate the firm’s WACC, assuming all of the required equity can be generated internally.
d) You have estimated that the firm will generate $1.5 million in internally-generated funds that are available to fund new investments. How much can the firm raise without issuing new equity, based on your previous calculations? What is the firm’s marginal cost of capital (MCC) for financing required beyond this figure?
problem 4: Shubenacadie Inc. is currently considering a project with a 5-year life that it believes has the potential to return the company to profitability. Based on the results from a marketing survey that cost the firm $100,000, Shubenacadie is convinced that there is a market for its proposed new product and is now ready to undertake a capital budgeting analysis of the proposed project. The following information has been collected for the purpose of determining the project’s net present value (NPV).
The project will require an initial investment of $5 million in new equipment and an investment of $250,000 in additional net working capital that will be released at the conclusion of the project. The cost to install the new equipment is estimated to be $75,000. The equipment is estimated to have a 5-year useful life with an expected salvage value at the end equal to 10% of its original purchase price. For accounting purposes, the new equipment will be depreciated on a straight-line basis. The equipment will be installed in a vacant building that Shubenacadie purchased last year for $1 million. The building, which has no alternative use, has a current market value of $1.25 million and is expected to have a market value of $1.5 million at the end of the project.
It is estimated that the project will generate net revenues before tax of $3 million per year. Finally, Shubenacadie’s marginal tax rate is 32% and its weighted average cost of capital is 11%. The applicable CCA rate on the new equipment is 12½%.
Required:
a) Estimate the initial after-tax cash outlay for the proposed project.
b) Estimate the net present value associated with the proposed project. Ignore CCA tax shields on the building.
c) Should Shubenacadie Inc. go ahead with this project? Briefly describe.
d) Given that Shubenacadie presently has 5 million common shares outstanding that are trading at $11.50 per share, what will be the new price per share if the firm accepts this project, assuming the markets are efficient?
problem 5:
You have been asked to determine the EPS indifference EBIT* level for your firm using the following information. Under the high-leverage alternative (a D/E ratio of 1.50), the firm would have 50,000 common shares outstanding, its pre-tax cost of debt would be 8%, and the face value of its outstanding debt would be $750,000. Under the low-leverage alternative (a D/E ratio of 0.80), the firm would have 75,000 common shares outstanding, its after-tax cost of debt would be 4% and the face value of its outstanding debt would be $250,000. The firm’s tax rate is 30%.
Required:
a) Determine the firm’s EPS indifference EBIT* given this information.
b) describe what the EPS indifference EBIT* is and how it can be used to assist the firm make its capital structure choice.
c) If the firm’s expected EBIT is $75,000, which capital structure alternative would you recommend?
problem 7:
a) After calculating a positive NPV, Renew Inc. has decided to undertake a four-year project to manufacture guardrails from recycled plastic. The project requires a $250,000 machine that will be amortized over four years on a straight-line basis for accounting purposes to an estimated salvage value of $25,000 at the end of the project. Renew is now trying to decide whether to lease the machine or to purchase it.
Additional information used in the NPV calculation is as follows. The project will require an additional investment in inventory of $50,000 and is expected to generate net (before-tax) operating cash flows of $100,000 per year over the life of the project. Employee training costs for the new machine are estimated to be $40,000. These training costs will be expensed in the current period for both tax and accounting purposes. Renews tax rate is 31%, its weighted average cost of capital is 12%, and the applicable CCA rate on the machine is 15%.
If Renew decides to lease the machine, it will have to make annual lease payments of $50,000 per year at the beginning of the year.
Determine whether Renew should lease or purchase the machine if its before-tax cost of borrowing is 9%.
b) Briefly describe three motivations for leasing.
problem 8:
BMP Consulting (BMPC) conducted an analysis of Delta Corp. and found that the firm consists of two different divisions: Pet Lovers, a pet supply retail outlet, and Able Move, a long-distance moving company. Delta is currently considering a project related to pet supplies and has asked for BMPC’s assistance with the analysis. As a part of its response, BMPC examined firms that operate within the industries of each of Delta’s two divisions, finding the following:
Firm Industry Cost of capital
Not Just Dogs Pet supply 8%
Canines and Felines Pet supply 10%
Reliable Movers Long-distance moving 14%
TransCanada Movers Long distance moving 18%
a) When is it appropriate to use the firm’s weighted average cost of capital (WACC) to evaluate a proposed investment?
b) Based on this information, what is a reasonable discount rate for BMPC to use in its assessment of the proposed pet supply project? Describe any assumptions that you make in arriving at this discount rate.
c) What would be the potential implications for Delta if WACC is used to evaluate the pet supply project?