photo 2&3 are professor’s explanation for question1

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1. Moma Vacations, Inc. is a US company in the travel and hotel businesses. (About half of the company’s revenue comes from each of these divisions.) They have asked you to compute a cost of capital for a new project.

They are considering opening a chain of new hotels along the US-Mexico border, with 20% of the revenues coming from the US and 80% from Mexico. You are given the following information:

· Comparable firms in each industry have been identified and the following averages computed:

D/E Ratio | Levered Beta | |

Travel Services | 20% | 1.01 |

Hotels | 50% | 1.43 |

· The market risk premium for the US is 6% and the market risk premium for Mexico is 9%. The US treasury bond rate is 2.5%.

· Moma has 50 million shares outstanding which trade for $20 per share. Moma also has operating lease obligations of $200 million per year for the next 5 years. Their pre-tax cost of debt is 4%. The company’s tax rate is 40%.

a. Find the US$ cost of capital for this project assuming they will finance the project entirely with equity. (3 points)

b. Now estimate the US$ cost of capital assuming they will finance the project with the sane mix of debt and equity that the company currently uses. (3 points)

2. You run a restaurant that is expected to generate $100,000 in EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) each year for the next five years (after which your lease terminates). If you invest $250,000 in renovating the restaurant today (depreciable straight line over five years to a salvage value of zero), you expect to increase your EBITDA **to **$175,000 a year for the next five years. If you face a tax rate of 40% and a cost of capital of 12%, would you invest in the renovation? (3 points)

3. You are planning to make an investment of $10 million in new servers for your business and expect to be able to depreciate that investment, straight line over five years down to a salvage value of zero. You have calculated the NPV of the project (with that assumption) to be $1 million.

If your tax rate is 40% and you were able to expense the investment today instead, what effect will that have on your NPV (assuming a cost of capital of 12%)? (3 points)

Example Test 2

4. (4 points) Houston Holograms (HH) is a home décor manufacturer located in Taos, NM. It is considering investing in a new business – concert promotion.

· HH has 5 million shares outstanding trading at $20 per share; its stock has a beta of 1.5.

· The firm has $20 million in interest bearing debt outstanding (in market and book value terms), and has operating lease commitments of $10 million each year for the next 5 years.

· The long-term Treasury bond rate is 4% and the market risk premium is 6%.

· The unlevered beta for other live entertainment related firms is 1.2.

· The pre-tax cost of debt for HH is 7%. The tax rate is 40%.

Estimate the cost of capital that you would use to analyze this project.

5. (5 points) Dallas Dolls (DD) is a California-based company that sells children’s toys. DD is considering investing $1 million in a new project to manufacture custom dolls meant to look like the customer and you have been asked to provide an analysis. You have been supplied with the following information:

· The initial investment will be capitalized and depreciated over the 5-year life of the project.

· The revenues are expected to be $6 million a year, each year for the next 5 years, and the Cost of Goods Sold is expected to be 75% of revenues in each of those years.

· DD’s annual G&A expenses are currently $5 million. If DD decides to invest in this project, the annual expenses will increase to $6 million and a third of these total expenses ($2 million) will be allocated to this project.

· The working capital investment (in inventory and accounts receivable) is expected to be 5% of annual revenues, with the investment occurring at the beginning of each year (when such investment is needed).

· When the project ends (in five years), the investment in working capital will be fully recovered.

· The cost of capital for this project is 10%. The tax rate is 40%.

Estimate the incremental, after-tax cash flows for this project in each year. (Please be clear about what you are doing.) What is the NPV of the project? Should they take the project?

6. (1 point) If this investment is made, DD will have to buy a new inventory management system in year 2 for $10 million. If the investment is not made, DD would have had to buy it anyway at the end of year 5 for $10 million. These costs would be expensed for tax purposes. What is the NPV of the project considering this requirement?

Example Test 3

7. (7 points) Candia Healthcare, a pharmaceutical firm, is considering investing in a new business – cosmetics.

· Candia has 250 million shares outstanding trading at $20 per share; its stock has a beta of 1.20.

· The firm has $1 billion in interest bearing debt outstanding (in market and book value terms), and has operating lease commitments of $300 million each year for the next 5 years.

· The long term Treasury bond rate is 6.5% and the market risk premium is 6%.

· The unlevered beta for other cosmetics firms is 1.05.

· The pre-tax cost of debt for Candia is 7%. The tax rate is 22%.

Estimate the cost of capital that you would use to analyze this project.

8. (8 points) Dunbarton Telephone is a company that provides residential and business phone service. Dunbarton is considering investing $1 billion in a segment of the telecommunication equipment business, and you have been supplied with the following information:

· The investment is expected to have a life of 5 years, over which period it will be depreciated straight line to a salvage value of $0.

· The revenues are expected to be $1.8 billion a year, each year for the next 5 years, and the Cost of Goods Sold is expected to be 75% of revenues in each of those years.

· Dunbarton’s G&A annual expenses are currently $100 million. If Dunbarton decides to invest in this project, the annual expenses will increase to $120 million. 25% of those $120 million total expenses will be allocated to this project.

· The working capital investment (in inventory and accounts receivable) is expected to be 10% of annual revenues, with the investment occurring at the beginning of each year (when such investment is needed).

· When the project ends, the investment in working capital will be fully recouped.

· The cost of capital for this project is 10%. The tax rate is 22%.

Estimate the incremental, after-tax cash flows for this project in each year. (Please be clear about what you are doing.) What is the NPV of the project? Should they take the project?

9. (3 point) If this investment is made, Dunbarton will have to buy a new computer to manage inventory in year 2 for $200 million. If the investment is not made, Dunbarton would have had to buy a new computer anyway at the end of year 5 for $200 million. These costs would be expensed immediately for tax purposes. What is the NPV of the project considering this requirement?

Example Test 4

1. (6 points) Mccarthy Corp., the largest ice carving equipment manufacturer in the world and it is considering an expansion. They have asked you to estimate a cost of capital.

The unlevered beta for the ice carving equipment industry is 1.3. The company’s stock recently traded for $50 per share and there are 800,000 shares outstanding. The company has debt outstanding consisting of 10-year bonds with a book value of $12 million and interest expenses last year were $600,000. The company’s debt has been rated AA by Standard & Poor’s and the average AA rated company has a default spread of 0.8%. The marginal tax rate for the company is 25%.

The 10-year U.S. Treasury bond is currently yielding 2.75%. The market risk premium is 5.5%.

What is the company’s cost of capital?

1. (6 points) Mccarthy is also considering entering the snowball machine business in a short-term (4-year) project.

· The project would require an initial investment of $60 million which would be depreciated over 4-years. (Straight-line depreciation. Zero salvage value.)

· Revenues would be $34 million in the first year, $40 million in the second year, and $50 million in years 3 and 4. Cost of Goods Sold would be 40% of revenues. The company would allocate 25% of revenues as G&A expense, but only half of that would actually be “caused by” the project.

· The project will require non-cash working capital of 5% of revenues (which will be recovered at the end of the project.

· The company’s marginal tax rate is 25%

· The cost of capital for the snowball machine industry is 8%. The cost of capital of the (U.S.) ice carving equipment industry is 9%. (Ignore your result for question 1.)

What is the NPV of the investment?

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