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1. (10 points) Two years ago, Ford Motor Company sold an issue of bonds with a 10-year maturity, a $1,000 par value, a 10 percent coupon rate, and semiannual interest payments. Now the going rate of interest on bonds such as these fell to 6 percent. At what price would the bonds sell?
2. (10 points) Greenville Corp. pays a constant $8 dividend on its stock. The company will maintain this dividend for the next seven years and will then cease paying dividends forever. If the required return on this stock is 8 percent, what is the current share price?
3. Suppose the current risk-free rate is 7.6 percent. Potpourri Inc. stock has a beta of 1.7 and an expected return of 16.7 percent. Assume the CAPM (Capital Asset Pricing Model) is true.
a. (8 points) What is the risk premium on the market?
b. (7 points) Magnolia Industries stock has a beta of 0.8. What is the expected return on the Magnolia stock?
4. (15 points) Consider the following cash flows on the two mutually exclusive projects.
Year Project A Project B
0 -$40,000 -$50,000
1 20,000 10,000
2 15,000 20,000
3 15,000 40,000
Cash flows of project A are expressed in real terms while those of project B are expressed in nominal terms. The appropriate nominal discount rate is 15 percent, and the inflation is 4 percent. According to Fisher’s Law:
(1+nominal rate of interest)=(1+real rate of interest)×(1+rate of inflation). Which project should you choose?
5. (5 points each×6=30 points) Which of the following cash flows should be treated as incremental cash flows when computing the NPV of an investment? Explain why/why not.
a. The reduction in the sales of the company’s other products.
b. The expenditure on plant and equipment.
c. The cost of research and development undertaken in connection with the product during the past three years.
d. The annual depreciation expense.
e. Dividend payments.
f. The resale value of plant and equipment at the end of the project’s life.
6. Broomfield Corporation has 6 million shares of common stock outstanding, 750,000 shares of 8 percent preferred stock outstanding, and 300,000 10 percent semiannual bonds outstanding, par value $1,000 each. The stock currently sells for $43 per share and has a beta of 1.1, the preferred stock currently sells for $75 per share, and the bonds have 15 years to maturity and sell for 103 percent of par. The market risk premium is 7 percent, T-bills are yielding 4 percent, and Broom field’s average federal-plus-state tax rate is 35 percent.
a. (10 points) What is the firm’s market value capital structure?
b. (10 points) If Broomfield is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should it use to discount the project’s cash flows?