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GB 550 Assignment Budgeting and Capital and Cash Flow Unit 5

Question 9-10:

The earnings, dividends and stock price of Shelby Inc. are expected to grow at 7% per year in

the future. Shelby’s common stock sells for $23 per share, its last dividend was $2.00, and the

company will pay a dividend of $2.14 at the end of the current year.

a) Using the discounted cash flow approach, what is its cost of equity?

b) If the firm’s beta is 1.6, the risk-free rate is 9% and the expected return on the market

is 13%, then what would be the firm’s cost of equity based on the CAPM approach?

c) If the firm’s bonds earn a return of 12%, then what would be your estimate of rs using the

over-own-bond-yield-plus-judgmental-risk-premium approach?

d) On the basis of the results of parts a through c, what would be your estimate of Shelby’s

cost of equity?

Questions 10-1 till 10-7

10-1 A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 8 years, and

a cost of capital of 12%. What is the project’s NPV?

Time line

Cash flows $12,000 $12,000 $12,000 $12,000 $12,000 $12,000 $12,000 $12,000

Year 0 1 2 3 4 5 6 7 8

10-2 Refer to problem 10-1. What is the project’s IRR?

10-3 Refer to problem 10-1. What is the project’s MIRR?

10-4 Refer to problem 10-1. What is the project’s PI?

10-5 Refer to problem 10-1. What is the project’s Payback period?

10-6 Refer to problem 10-1. What is the project’s Discounted payback period?

10-7 Your division is considering two investment projects, each of which requires an upfront

expenditure of $15 million. Your estimate that the investments will produce the following

net cash flows:

Year Project A Project B

1 $5,000,000 $20,000,000

2 $10,000,000 $10,000,000

3 $20,000,000 $6,000,000

a) What are the two projects’ net present values, assuming a cost of capital of 5%, 10% and 15%?

b) What are the two projects’ IRRs at these same costs of capital?


Question 13-5:

How is it possible for an employee stock option to be valuable even if the

firm’s stock price fails to meet shareholder’s expectations?

Question 15-8

The Rivoli company has no debt outstanding, and its financial position is given

by the following data:

Assets (book=market): $3,000,000

EBIT $500,000

Cost of equity, rs = 10%

Stock price, P0= $15

Shares outstanding, no = 200,000

Tax rate, T (federal-plus-state) 40%

The firm is considering selling bonds and simultaneously repurchasing some of its

stock. If it moves into a capital structure with 30% debt based on market values,

its cost of equity, rs will increase to 11% to reflect the increased risk. Bonds can

be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are

paid out as dividends. Earnings are expected to be constant over time.

a) What effect would this use of leverage have on the value of the firm?

b) What would be the price of Rivoli’s stock?

c) What happens to the firm’s earnings per share after the recapitalization?

d) The $500,000 EBIT given previously is actually the expected value from the following

probability distribution.

Probability EBIT

0.1 ($100,000)

0.2 200,000

0.4 500,000

0.2 800,000

0.1 1,100,000

Determine the times-interest earned ratio for each probability.

What is the probability of not covering the interest payment at the 30% debt level?

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