Ivanova Olesia Assignment 2

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Humber College *

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350

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Finance

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Jan 9, 2024

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Corporate Finance BFIN350 Assignment #2 Complete all questions. Place only final answers in ‘boxed answer area’. Include details of your work below the ‘boxed answer area’ (mandatory). Show all calculations, formulas used, financial calculator inputs/buttons. State all assumptions. Submit a single MS Word document. Submit an attachment in the Assignment area of the course site. Submit on time per the Critical Path. Late assignments are subject to 20% penalty per day and will not be accepted after 5 days late. Note the Humber College policy on plagiarism . Please note this applies equally to copying copyright materials as it does to using your friends’ solutions to problems. If I notice ‘copy and paste’ duplications in submissions all parties identified will be awarded zero grades with potentially additional implications. While I encourage students to work together and support each other on course work, you are all aware of the differences between this and copying another’s work. Respect this and your will learn more, faster! Page 1 of 6

Corporate Finance BFIN350 There are two projects. Project Everest has an outflow of cash of $34,000 in years 0 and 1, followed by an inflow of $49,000 in each of the years 2 and 3. Project Seabed has a cash outflow of $60,000 in year 0, followed by an inflow of $29,000 in years 1, 2, and 3. a) If the profitability index decision rule applies and the required return is 7.5%, which project should be selected? b) If the NPV decision rule applies then which project should be selected? Answer Place only your final answer in the box. Question Your Response a) Profitability Index - Which Project? Project Seabed b) NPV – Which Project? Project Everest Show your work here (mandatory): a) Formula for PI is: PI = (PV of investment’s future cash flows) / (Initial cost) For Project Everest: The initial cost: 34,000 + 34,000 = 68,000 PV = 49,000 / 1.075^2 + 49,000 / 1.075^3 = 81,844.3659 PI = 81,844.3659 / 68,000 = 1.20359 For Project Seabed: The initial cost (investment) is the cash outflow in year 0, which is $60,000. PV = 29,000 / 1.075^1 + 29,000 / 1.075^2 + 29,000 / 1.075^3 = 75,415.246 PI = 75,415.246 / 60,000 = 1.25692 b) For Project Everest: NPV = -34,000 + (-34,000) / 1.075 + 49,000 / 1.075^2 + 49,000 / 1.075^3 = 16,216.459 For Project Seabed: NPV = -60,000 + 29,000 / 1.075 + 29,000 / 1.075^2 + 29,000 / 1.075^3 = 15,415.246 Page 2 of 6

Corporate Finance BFIN350 You need to choose between two machines based on the following information: Machine 1 has a 4 year life, costs $322,500 with pre-tax operating costs of $64,500 per year. Machine 2 has a 3 year life, costs $425,250 with pre-tax operating costs of $39,600 per year. Both machines have a salvage value of $22,500 and are classed with a CCA rate of 18% per year. The company tax rate is 30% and the discount rate is 10%. a) What is the EAC? b) Which machine would you select as an investment? Answer Place only your final answer in the box. a) EAC? The Equivalent Annual Cost (EAC) is a measure used to compare the cost-effectiveness of different systems or machines over their respective lifetimes. It takes into account the initial cost, operating costs, salvage value, and the time value of money. EAC1 = 166,232.278 EAC2 = 210,333.068 b) Which Machine? Machine 1 Show your work here (mandatory): a) The formula for EAC is: EAC = (PV of costs – PV of salvage value) / annuity factor Annuity factor = (1 – (1 + discount rate)^-number of years) / discount rate Machine 1: PV of costs = 322,500 + 64,500 / 1.1 + 64,500 / 1.1^2 + 64,500 / 1.1^3 + (64,500 + 22,500) / 1.1^4 = 542,324.124 PV of salvage value = 22,500 / 1.1^4 = 15,367.80275 Annuity factor = = (1 – (1 + 0.1)^-4) / 0.1 = 3.17 EAC1 = (542,324.124 - 15,367.803) / 3.17 = 166,232.278 Machine 2: PV of costs = 425,250 + 39,600 / 1.1 + 39,600 / 1.1^2 + (39,600 + 22,500) / 1.1^3 = 540,633.922 PV of salvage value = 22,500 / 1.1^3 = 16,904.583 Annuity factor = = (1 – (1 + 0.1)^-3) / 0.1 = 2.49 EAC2 = (540,633.922 - 16,904.583) / 2.49 = 210,333.068 b) The Machine 1 (EAC = 166,232.278) with the lower EAC would be the better investment. Page 3 of 6

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Corporate Finance BFIN350 A stock has an expected return of 17.5% and a beta of 1.65. Another asset which has low risk with a beta of .25 is earning 3.25% a) What is the expected return on a portfolio that is comprised of one-half the higher risk stock and one-half the lower risk asset? b) Calculate the weights of each of these if they are the only 2 holdings in a portfolio which has a beta of 1.00. c) If the portfolio of these two holdings earned 10%, what would be the beta of the portfolio? Answer Place only your final answer in the box. a) Expected Return? 10.375% b) Weight of each holding? w1 = 0.536 w2 = 0.464 c) Beta? 1.00 Show your work here (mandatory): a) Formula for Rp: Rp = w1 * R1 + w2 * R2 where: - w1 and w2 are the weights of the assets in the portfolio (0.5 for both in this case) - R1 and R2 are the expected returns of the assets (17.5% for the higher risk stock and 3.25% for the lower risk asset) Rp = 0.5 * 17.5% + 0.5 * 3.25% = 10.375% b) The formula for βp is: βp = w1 * β1 + w2 * β2 where: - w1 and w2 are the weights of the assets in the portfolio - β1 and β2 are the betas of the assets (1.65 for the higher risk stock and 0.25 for the lower risk asset) - Given that the portfolio beta is 1.00 1.00 = w1 * 1.65 + w2 * 0.25 w1 + w2 = 1 w1 = 0.536 w2 = 0.464 c) Beta of the Portfolio The beta of the portfolio would still be calculated as: βp = w1 * β1 + w2 * β2 = 0.536 * 1.65 + 0.464 * 0.25 = 1.00 Page 4 of 6

Corporate Finance BFIN350 If the market risk premium is 5.8% and company has the following: Common Stock: 6850000 shares outstanding, selling at $28 per share, beta 1.6 Preferred Stock: 350,000 shares outstanding, 4.8% yield, selling at $88.5 per share Debt: 138000 5.5% semi annual bonds outstanding, par value $1000 each with 12 years to maturity, selling at 117% of par Tax Rate: 30% a) Calculate the company`s market value b) Calculate the percentage of the market value capital structure that is debt c) Calculate the percentage of the market value capital structure that is common shares d) Calculate the percentage of the market value capital structure that is preferred shares e) Discuss (3 to 10 sentences) how the matter of risk relates to capital structure Answer Place only your final answer in the box. a) Market Value? 384,235,000 b) Debt percentage 42.021% c) Common Share percentage 49.917% d) Preferred Share percentage 8.061% e) Risk and Capital Structure The capital structure of a company is directly related to its risk profile. A company with a high proportion of debt in its capital structure is considered more risky because it has to make regular interest payments and repay the principal amount at maturity. On the other hand, equity does not have such obligations, making it less risky. However, a higher equity proportion might indicate that the company is not taking advantage of the tax shield provided by debt. Therefore, companies often strive for a balanced capital structure that minimizes the cost of capital while also managing risk. Show your work here (mandatory): a) Market value of common stock = Number of shares * Price per share Market value of preferred stock = Number of shares * Price per share Market value of debt = Number of bonds * Price per bond Common stock value = 6,850,000 * 28 = 191,800,000 Preferred stock value = 350,000 * 88.5 = 30,975,000 Debt value = 138,000 * 1,000 * 1.17 = 161,460,000 Page 5 of 6

Corporate Finance BFIN350 Total market value = 191,800,000 + 30,975,000 + 161,460,000 = 384,235,000 b) Debt percentage = (Debt value / Total market value) * 100 = (161,460,000 / 384,235,000) * 100 = 42.021% c) Common share percentage = (Common stock value / Total market value) * 100 = (191,800,000 / 384,235,000) * 100 = 49.917% d) Preferred share percentage = (Preferred stock value / Total market value) * 100 = (30,975,000 / 384,235,000) * 100 = 8.061% Page 6 of 6

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