frozen pizza,

Homework 3

FIN302 O&P, Zhun Liu

November 16, 2016

Question 1

Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be from new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version.

a) Assume that before the new pizza is introduced, customers spend the same amount ($20 million) on the original version. What level of incremental sales is associated with introducing the new pizza? (Round to two decimal places.)

b) Suppose that 50% of the customers who would have switched from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case? (Round to two decimal places.)

Question 2

Cellular Access, Inc., a cellular telephone service provider reported net income of $250 million for the most recent fiscal year. The firm had depreciation expenses of $100 million, capital expenditures of $200 million, and no interest expenses. Net working capital increased by $10 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year.

Question 3

Daily Enterprises is purchasing a $10 million machine. It will cost $50, 000 to transport and install the machine. The machine has a depreciable life of five years using straight-line depreciation and will have no salvage value. The machine will generate incremental revenues of $4 million per year along with incremental costs of $1.2 million per year. Daily’s marginal tax rate is 35%. You are forecasting incremental free cash flows for Daily Enterprises. What are the incremental free cash flows associated with the new machine?

a) The free cash flow for year 0? (Round to the nearest dollar.)

b) The free cash flow for years 1-5? (Round to the nearest dollar.)

Question 4

You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, ”We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.” You open the report and find the following estimates (in millions of dollars):

Project Year

Earnings Forecast Year 1 Year 2 · · · Year 4 Year 5

Sales Revenue 30 30 30 30

-Cost of Goods Sold 18 18 18 18

= Gross Profit 12 12 12 12

General, Sales and Administrative Expenses 2 2 2 2

Depreciation 2.5 2.5 2.5 2.5

= Net Operating Income 7.5 7.5 7.5 7.5

Income Tax 2.625 2.625 2.625 2.625

= Net Income 4.875 4.875 4.875 4.875

All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the account- ing department recommended. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase earnings by $4.875 million per year for 10 years, the project is worth $48.75 million. You think back to your glory days in finance class and realize there is more work to be done!

First, you note that the consultants have not included the fact that the project will require $10 million in working capital up front (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general, and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on!

a) Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project?

b) If the cost of capital for this project is 14%, what is your estimate of the NPV of the new project? Should we accept this project or not?

Question 5

You are a risk-averse investor who is considering investing in one of two economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move together in good times all prices rise together, and in bad times they all fall together. In the second economy, stock returns are independent one stock increasing in price has no effect on the prices of other stocks. Which economy would you choose to invest in? Explain. (Select the best choice below.)

A. A risk averse investor is indifferent in both cases because he or she faces unpredictable risk. B. A risk averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together. C. A risk averse investor would choose the economy in which stocks move together because the uncer- tainty is much more predictable, and you have to predict only one thing. D. A risk averse investor would choose the economy in which stock returns are independent because risk can be diversified away in a large portfolio.

Question 6

You are considering how to invest part of your retirement savings.You have decided to put $200, 000 into three stocks: 50% of the money in GoldFinger (currently $25/share), 25% of the money in Moosehead (currently $80/share), and the remainder in Venture Associates (currently $2/share). Suppose GoldFin- ger stock goes up to $30/share, Moosehead stock drops to $60/share, and Venture Associates stock rises to $3/share.

a) What is the new value of the portfolio?

b) What return did the portfolio earn?

c) If you don’t buy or sell any shares after the price change, what are your new portfolio weights?

Question 7

Arbor Systems and Gencore stocks both have a volatility of 40%.

a) Compute the volatility of a portfolio with 50% invested in each stock if the correlation between the stocks is (a) +1, (b) 0.5, (c) 0, (d) −0.5, and (e) −1

b) In which of the cases is the volatility lower than that of the original stocks?

Question 8

You have a portfolio with a standard deviation of 30% and an expected return of 18%. You are considering adding one of the two stocks in the following table. If after adding the stock you will have 20% of your money in the new stock and 80% of your money in your existing portfolio, which one should you add?

Expected Standard Correlation with Your

Return Deviation Portfolio’s Returns

Stock A 15% 25% 0.2

Stock B 15% 20% 0.6

Question 9

Your client has invested $100, 000 in stock A. She would like to build a two-stock portfolio by investing another $100, 000 in either stock B or C. She wants a portfolio with an expected return of at least 14% and as low a risk as possible, but the standard deviation must be no more than 40%. What do you advise her to do, and what will be the portfolio expected return and standard deviation?

Expected Return Standard Deviation Correlation with A

A 15% 50% 1

B 13% 40% 0.2

C 13% 40% 0.3

Question 10

You hear on the news that the S&P 500 was down 2% today relative to the risk-free rate (the market’s excess return was −2%). You are thinking about your portfolio and your investments in Zynga and Proctor and Gamble.

a) If Zynga’s beta is 1.4, what is your best guess as to Zynga’s excess return today?

b) If Proctor and Gamble’s beta is 0.5, what is your best guess as to P&G’s excess return today?

Question 11

Suppose the risk-free return is 4% and the market portfolio has an expected return of 10% and a standard deviation of 16% . Johnson & Johnson Corporation stock has a beta of 0.32. What is its expected return?

Question 12

You are thinking of buying a stock priced at $100 per share. Assume that the risk-free rate is about 4.5% and the market risk premium is 6%. If you think the stock will rise to $117 per share by the end of the year, at which time it will pay a $1 dividend, what beta would it need to have for this expectation to be consistent with the CAPM? (Hint: relate to what you have learned in Equity Valuation)

Question 13

You are analyzing a stock that has a beta of 1.2. The risk-free rate is 5% and you estimate the market risk premium to be 6% . If you expect the stock to have a return of 11% over the next year, should you buy it? Why or why not?

Question 14

Andyco, Inc., has the following balance sheet and an equity market-to-book ratio, defined as market value of equity divided by book value of equity, of 1.5. Assuming the market value of debt equals its book value, what weights should it use for its WACC calculation?

Assets Liabilities & Equity

$1, 000 Debt $400

Equity $600

Question 15

Consider a simple firm that has the following market-value (unlike Question 14) balance sheet:

Assets Liabilities & Equity $1, 000 Debt $400

Equity $600

Next year, there are two possible values for its assets, each equally likely: $1, 200 and $960. Its debt will be due with 5% interest. Because all of the cash flows from the assets must go either to the debt or the equity, if you hold a portfolio of the debt and equity in the same proportions as the firm’s capital structure, your portfolio should earn exactly the expected return on the firm’s assets. Show that a portfolio invested 40% in the firm’s debt and 60% in its equity will have the same expected return as the assets of the firm. That is, show that the firm’s WACC is the same as the expected return on its assets.

Question 16

Laurel, Inc., has debt outstanding with a coupon rate of 6% and a yield to maturity of 7%. Its tax rate is 35% . What is Laurel’s effective (after-tax) cost of debt? NOTE: Assume that the debt has annual coupons.

Question 17

CoffeeCarts has a cost of equity of 15% , has an effective cost of debt of 4% , and is financed 70% with equity and 30% with debt. What is this firm’s WACC?

Question 18

RiverRocks, Inc., is considering a project with the following projected free cash flows:

Year 0 1 2 3 4 Cash Flow (in millions) -$50 $10 $20 $20 $15

a) Draw the timeline of the project’s cash flows.

b) The firm believes that, given the risk of this project, the WACC method is the appropriate approach to valuing the project. RiverRocks’ WACC is 12%. Should it take on this project? Why or why not?

Question 19

CoffeeStop primarily sells coffee. It recently introduced a premium coffee-flavored liquor (BF Liquors). Suppose the firm faces a tax rate of 35% and collects the following information. If it plans to finance 11% of the new liquor-focused division with debt and the rest with equity, what WACC should it use for its liquor division? Assume a cost of debt of 4.8%, a risk-free rate of 3%, and a market risk premium of 6%.

Beta % Equity % Debt CoffeeStop 0.61 96% 4% BF Liquors 0.26 89% 11%