Introduction to Managerial Finance

FINE 5200G, Winter 2015

Solution to Assignment #2
Question 1 (25%)
a) (15%)
Status quo (3%):

P0 =

2.5 1.03
= 36.79
0.1 0.03

P0 =

2.5 1.06
= 44.17
0.12 0.06

Timber expansion (3%):

Retail expansion (8%):

Dividends in the next four years (2%):
D1 = 2.5 (1 + 0.12) = 2.80

D2 = 2.5 (1 + 0.12) 2 = 3.136

D3 = 2.5 (1 + 0.12) 3 = 3.5123

D4 = 2.5 (1 + 0.12) 4 = 3.9338

The stock price in three years (3%):
3.9338 1.05
P4 =
= 45.89
0.14 0.05
The stock price today (3%):
2.80 3.136 3.5123 3.9338 45.8943
P0 =
+
+
+
= 36.74
+
2
1.14 3
1.14 4 1.14 4
1.14 1.14

Decision (1%): Strategy b) leads to the highest stock price, the best of the three alternatives.
b) (5%)
If the company continued on its current path, the stock would have returned exactly 10% a
year over any future time period.
If the company adopts the strategy you recommend in a), its stock price would rise to:
2.5 1.064
P3 =
= 52.6032
0.12 0.06
in three years.
The expected return (IRR) over the three-year holding period is thus:
2.50 1.06 2.50 1.06 2 2.50 1.06 3 + 52.6032
36.79 =
+
+
1+ R
(1 + R ) 2
(1 + R ) 3
and the solution is R = 19.46%,
c) (5%)
Your friend wouldve bought the stock for P0 = $44.17 as calculated in a) above.
The stock price in 3 years is expected to be:
1

2.5 1.064
= 52.6032
0.12 0.06
The expected return (IRR) over the three-year holding period is thus:
2.50 1.06 2.50 1.06 2 2.50 1.063 + 52.6032
44.17 =
+
+
1+ R
(1 + R ) 2
(1 + R ) 3
and the solution is R = 12% or exactly the required rate of return.

P3 =

Question 2 (20%)
a) (15%)
Portfolio I is just Stock A, so its return in each state of the economy is already known:
State
1
2
3
4

Prob.
0.15
0.30
0.40
0.15

Return
0.00
0.05
0.10
0.20

o Its expected return (i.e., mean) is:

0.15 0.00 + 0.30 0.05 + 0.40 0.10 + 0.15 0.20 = 0.085

o Its standard deviation is:

0.15 (0 0.085) 2 + 0.30 (0.05 0.085) 2 + 0.4 (0.1 0.085) 2 + 0.15 (0.2 0.085) 2 = 0.0594

Similarly, Portfolio V is just Stock B and its expected return and standard deviation,
calculated in the same way, are 0.1325 and 0.1408, respectively.

For Portfolios II-IV, we can proceed as follows:

o For each portfolio (e.g., II), work out its return for each of the 4 states of the
world:

For example, Portfolio IIs return in State 1 is:
0.250.00 + 0.750.40 = 0.3

The calculation in other states is similar.
o Given portfolio returns for all the states, we then calculate the portfolios
expected return and standard deviation as before.
o The results are summarized below for each portfolio (5% for each of the three
Portfolios):

Portfolio II:
State
1
2
3
4

Prob.
0.1
0.4
0.4
0.1
Mean
St. dev

Return
0.3
0.1625
0.1
0.05
0.14
0.0649

Prob.

Return

Portfolio III:
State

1
2
3
4

0.2
0.125
0.075
0.075
0.1088
0.0442

Prob.
0.15
0.3
0.4
0.15
Mean
St. dev

Return
0.1
0.0875
0.0875
0.1375
0.0969
0.0176

Portfolio IV:
State
1
2
3
4

0.15
0.3
0.4
0.15
Mean
St. dev

Summary for all five portfolios:

Weight in Stock A
0
0.25
0.5
0.75
1

Return
0.1325
0.1206
0.1088
0.0969
0.0850

St. Dev
0.1408
0.0920
0.0442
0.0176
0.0594

Portfolio
I (Stock B)
II
III
IV
V (Stock A)

b) (5%)
0.14
B

Expected return

0.13
II

0.12
0.11

III

0.10
IV
0.09
A
0.08
0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

Stardard deviation

Portfolio V (or Stock A) is ruled out as a preferred choice because it is clearly dominated by
both Portfolios III and IV: both portfolios have better expected returns and lower risk.
3

For the remaining 4 portfolios (I-IV), there is no domination (i.e., no portfolio with the
highest return and lowest risk). Its a trade-off between risk and return.
One way to make a choice is to apply the Sharpe ratio to evaluate the risk-return trade-off:
Weight in Stock A
0
0.25
0.5
0.75
1

Return
0.1325
0.1206
0.1088
0.0969
0.0850

St. Dev
0.1408
0.0920
0.0442
0.0176
0.0594

Portfolio
I (Stock B)
II
III
IV
V (Stock A)

Sharpe
0.728
0.985
1.781
3.795
0.926

The Sharpe ratio suggests that Portfolio IV provides the best trade-off between risk and
return.

Question 3 (20%)
Payback period calculation (5%):

Year

Project A
0
1
2
3
4
5

-110000
60000
40000
30000
10000
10000

Project B

Payback period calculation

Cash flow
Payback period
Project Project Project Project
A
B
A
B

-110000
-110000
10000
-50000
20000
-10000
30000
20000
45000
30000
80000
40000
10000
Payback A = 2 +
= 2.33 , Payback B
30000

-110000
-100000
-80000
-50000
2.33
0
80000
5000
=4+
= 4.06
80000

4.06

NPV calculation (5%):

60000 40000 30000 15000 5000
+
+
+
+
110000 = 9182.50
1.12
1.12 2
1.12 3 1.12 4 1.12 5
10000 20000 30000 45000 80000
NPV B =
+
+
+
+
110000 = 10218 .32
1.12
1.12 2
1.12 3
1.12 4
1.12 5
NPV A =

PI calculation (4%):
60000 40000 30000 15000 5000
+
+
+
+
1.12 2
1.12 3 1.12 4 1.12 5 = 1.083
PI A = 1.12
110000
10000 20000 30000 45000 80000
+
+
+
+
1.12 2
1.12 3
1.12 4
1.12 5 = 1.093
PI B = 1.12
110000

IRR calculation (4%):

60000 40000
30000
15000
5000
+
+
+
+
110000 = 0 IRR A = 16.73%
2
3
4
1 + R (1 + R )
(1 + R )
(1 + R )
(1 + R ) 5
10000 20000
30000
45000
80000
+
+
+
+
110000 = 0 IRR B = 14.73%
2
3
4
1 + R (1 + R )
(1 + R )
(1 + R )
(1 + R ) 5

Recommendation (2%):
o From the above calculations, the payback and IRR methods support Project A while
the NPV and PI methods support Project B.
o Whenever there are conflicting rankings, we should rely on the NPV criterion to
make decisions. So Project B should be chosen.

Question 4 (35%)
a) (25%)
Operating CF projection:
o Unit sale projections for the next three years are provided in the question. Beyond that, zero
growth in unit sales is expected.
o Unit price, currently at $2.80, rises at 2% rate of inflation each year.
o COGS gross is projected using percentage of sales, i.e., it is 35.3/100.8 = 35.00% of sales.

NOTE: You may project COGS using a different approach (i.e., other than percentage of
sales), as long as you provide a reasonable rationale for them.
o Operating savings per unit are $0.031 in todays dollars, which grows at the rate of inflation
(2% per year): $0.0311.02t units.

NOTE: The per unit savings apply to all frozen pizzas, from both current operations and
expansions.
o Annual operating savings are $140,000 in todays dollars, which grows at the rate of
inflation (2% per year): $140,0001.02t.
o CCAs are provided in the question.
o Tax rate is 35%, given in the question.
0
Sales -units:
Unit price
Sales - total:
COGS - gross:
Savings-expansion:
Savings-current:
COGS - net:
Oper. Exp. - gross:
Ann. Savings:
Oper. Exp. - net:
CCA:
EBIT
Taxes:
NI:
Operating CF:

1
7.2
2.856
20.563
7.197
0.228
1.138
5.831
11.310
0.143
11.167
1.377
2.188
0.766
1.422
2.799

2
13.2
2.913
38.453
13.459
0.426
1.161
11.872
21.149
0.146
21.004
2.436
3.142
1.100
2.042
4.478

3
17.4
2.971
51.702
18.096
0.572
1.184
16.339
28.436
0.149
28.288
1.881
5.194
1.818
3.376
5.257

4
17.400
3.031
52.736
18.458
0.584
1.208
16.666
29.005
0.152
28.853
1.464
5.753
2.014
3.739
5.203

5
17.400
3.091
53.791
18.827
0.596
1.232
16.999
29.585
0.155
29.430
1.146
6.215
2.175
4.040
5.186

6
17.400
3.153
54.867
19.203
0.607
1.257
17.339
30.177
0.158
30.019
0.909
6.600
2.310
4.290
5.199

7
17.400
3.216
55.964
19.587
0.620
1.282
17.686
30.780
0.161
30.619
0.484
7.175
2.511
4.664
5.148

8
17.400
3.281
57.083
19.979
0.632
1.308
18.040
31.396
0.164
31.232
0.588
7.224
2.528
4.696
5.284

9
17.400
3.346
58.225
20.379
0.645
1.334
18.400
32.024
0.167
31.856
0.483
7.485
2.620
4.865
5.348

Additions to net working capital (NWC) in the project:

o Accounts receivables, inventory and accounts payable are all projected using % sales.
5

10
17.400
3.413
59.389
20.786
0.658
1.360
18.768
32.664
0.171
32.494
5.493
2.635
0.922
1.712
7.205

o From last years balance sheet, these three items are 12.1/100.8 = 12.00%, 7.1/100.8 =
7.00%, and 8.1/100.8 = 8.00% of sales.
o Combining with the sales projections above (from the expansion project, not the firm as a
whole), we have the projections for accounts receivables, inventory and accounts payable.
o Additions to NWC is the just the increase in NWC each year.
o The total amount of the NWC in the final year ($1.404 million) is recovered at the end of
that year.
NWC projection
Accounts receivables
Inventory
Accounts payable
NWC
Additions to NWC

0.750
0.750

1
2.468
1.439
1.645
2.262
1.512

2
4.614
2.692
3.076
4.230
1.968

3
6.204
3.619
4.136
5.687
1.457

4
6.328
3.692
4.219
5.801
0.114

5
6.455
3.765
4.303
5.917
0.116

6
6.584
3.841
4.389
6.035
0.118

7
6.716
3.917
4.477
6.156
0.121

8
6.850
3.996
4.567
6.279
0.123

9
6.987
4.076
4.658
6.405
0.126

10
7.127
4.157
4.751
6.533
0.128

Sum
6.533

Total cash flow and NPV calculation:

0

Operating CF:
Additions to NWC

-0.750

10

2.799

4.478

5.257

5.203

5.186

5.199

5.148

5.284

5.348

7.205

-1.512

-1.968

-1.457

-0.114

-0.116

-0.118

-0.121

-0.123

-0.126

-0.128

NWC recovery:

6.533

Initial capital:

-16.500

Salvage value:

Total CF:

-17.250

NPV:

1.287

2.510

3.800

5.090

5.070

5.080

5.027

5.160

5.223

13.610

4.319

So, the NPV of the proposed expansion project is $4.319 million:

17.25 +

1.287 2.510 3.800 5.090 5.070 5.080 5.027 5.160 5.223 13.610
+
+
+
+
+
+
+
+
+
= 4.319
1.15 1.15 2 1.153 1.154 1.155 1.156 1.157 1.158 1.159 1.1510

Approve the project.

b) (5%)
Cost of equity:
0 .0206 + 1 .2 0 .05 = 0 .1026

WACC:
0 .0706 (1 0 .35 ) 0.4 + 0.1026 0.6 = 0 .0825

c) (5%)
Recalculate NPV using WACC = 8.25% as the hurdle rate (keeping everything else the same as
before):
1.287
2.510
3.800
5.090
5.070
5.080
5.027
+
+
+
+
+
+
2
3
4
5
6
1.0825 1.0825 1.0825 1.0825 1.0825 1.0825 1.08257
5.160
5.223
13.610
M+
+
+
= 13.694
8
9
1.0825 1.0825 1.082510

17.25 +

With either hurdle rate, the NPV is positive.

o The question is then how high must the hurdle rate go before the NPV is reduced to
zero? To answer that question, we calculate the IRR of the project::

17.25 +

1.287
2.510
3.800
5.090
5.070
5.080
5.027
5.160
5.223
13.610
+
+
+
+
+
+
+
+
+
=0
2
3
4
5
6
7
8
9
1 + R (1 + R )
(1 + R ) (1 + R )
(1 + R )
(1 + R )
(1 + R )
(1 + R )
(1 + R )
(1 + R )10

and we find that IRR = 19.71%. So as long as the hurdle rate is less than 19.71%, we
should accept the project. As it is quite unlikely for the hurdle rate to rise from the
current WACC of 8.25% to 19.71%, the expansion project is most likely a positive
NPV project. Accept the project.