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Ownership Considered Equity And Ownership Considered Debt

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  • Category: Finance

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Question #1: (Twenty Points)
(a). Why is stock ownership considered equity and bond ownership considered debt?

In finance you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner’s equity because he or she can readily sell the item for cash. Stocks are equity because they represent ownership in a company. When a company needs money, the solution is to raise money by issuing bonds to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

(b). I am considering buying a stock, the stock has a beta coefficient of 1.5, the current risk free rate in the market place (10 year T-Notes) is 3.0%, and the market risk premium is 5%. What is the required rate of return on this firm’s stock?

Βstock = 1.5
RFR = .003
Rmarket = .05
E(R) = the required rate of return

E(R) = RFR + βstock (Rmarket – RFR)
E(R) = 0.03 + 1.5 (0.05 – 0.03)
E(R) = 0.03 + 1.5 (0.02)
E(R) = 3.06%

Question #2: (Twenty Points)
Sexton Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. Please determine the NPV, IRR, Profitability Index and Payback for these two Projects.

WACC: 10.25%
Year 0 1 2 3 4
CFS -$2,050 $ 750 $ 760 $ 770 $ 780
CFL -$4,300 $1,500 $1,518 $1,536 $1,554

Question #3: (Twenty Points)
A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock’s current price?

D1 = $0.75
rs = 10.5%
g = 6.4%
Po = Stock Current price

Po = D1/(rs – g)
Po = $0.75/(.105 – .064)
Po = $18.29

Question #4: (Twenty Points)
You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt and 60% common equity. The firm’s interest rate on debt is 8.0% and their tax rate is 25%. The cost of common equity using retained earnings is 12.75%. What is its WACC?

rD = .008
Tc = .25
D/V = .40
re = .1275
E/V = .60

WACC = rd(1-Tc)*(D/V)+re*(E/V)
WACC = .008(1-.25)*.40+.1275*.60
WACC = .0024+.0765
WACC = 7.89%

Question #5: (Twenty Points)
(a). Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? a. Changes in net working capital.
b. Shipping and installation costs.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.

(b). A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

a. All sunk costs that have been incurred relating to the project. b. All interest expenses on debt used to help finance the project. c. The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project’s life. d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.

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