Question 16 ABC Company is a construction company which is considering purchasin
ID: 2789759 • Letter: Q
Question
Question 16
ABC Company is a construction company which is considering purchasing an automatic concrete loading machine. The new machine will cost $600,000 and have a useful life of 5 years. To operate the machine the ABC will hire one operator at a cost of $120,000 annually and incur maintenance costs of $75,000 annually. The machine would be depreciated on a straight line basis to zero at the end of its useful life.
If the company invests in this machine, there will be an increase in revenue from sale of concrete of $235,000. The firm is also likely to experience an increase in the profits from lumber by $185,000 annually.
Assume all cash flows are after-tax and the company’s cost of capital is 10%.
A. Calculate the incremental after-tax cash flows for the loading machine.
B. Determine whether or not ABC should purchase the machine based on the Net Present Value of the decision.
C. Briefly explain why bond prices vary negatively with interest rate movements
Question 17
The following balance sheet extract relates to the Allied Insurance Company
Bonds Payable $1,000,000 Common Stock $3,000,000
Additional Information:
The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.
The company’s common shares which have a book value of $25 per share are currently selling at $20 per share.
The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%
The company’s tax rate is 30%.
Calculate Allied’s cost of debt.
Calculate Allied’s cost of equity.
Calculate Allied’s market value weighted average cost of capital.
Explain why the cost of debt is cheaper than the cost of equity.
Question 18
Following is data on 2 stocks and the market portfolio
Required:
Calculate the expected returns on stocks X and Y.
Calculate the standard deviation of X and Y respectively, and determine which stock is riskier.
If you have $40,000 and you put $10,000 in stock X and $30,000 in stock Y, what will be the expected return on such a portfolio?
Considering the following:Two investors are evaluating AT & T’s stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. Is it true that they should both be willing to pay the same price for AT & T’s stock? Explain based on how stocks are valued.
Explanation / Answer
There are many different questions here. As per rules, I will answer only the first 4 sub-parts
Q16
We ignore the tax effect on depreciation since tax rate is not given.
NPV is computed using =NPV(10%, Cash flows from years 1-5)+ Cash flow in year 0
A&b. The cash flows and NPV is presented in the table below
Since NPV is positive, the machine should be purchased.
C. Bond prices increase with a fall in interest rate and vice versa. This is because when the interest rate increases, the investors expect a higher return from their investments. The bond becomes less attractive compared to other investments in the market and hence its price falls. In case of a fall in interest rate, the bond becomes more attractive than other investments and its price tends to increase.
Q17- A
Cost of debt = YTM of bonds after tax
YTM of bonds is computed using RATE function in excel as =RATE(9,80,-950,1000)
where 9= period till maturity
80 = coupon amount=8%*1000
950= PV of bond= 95%*1000
1000 = FV of the bond
YTM = 8.83%
Cost of debt = 8.83%*(1-30%)
= 6.18%
Year Initial cost Operator cost Maintenance Increase in revenue Increase in profits Net cash flows 0 -600000 -600000 1 -120000 -75000 235000 185000 225000 2 -120000 -75000 235000 185000 225000 3 -120000 -75000 235000 185000 225000 4 -120000 -75000 235000 185000 225000 5 -120000 -75000 235000 185000 225000 NPV $ 252,927.02