AFIN 102 Group Assignment Session 2, 2017

Group Assignment

AFIN 102

Due: 5pm on Friday, 20th October, 2017

Please use the excel template in organizing your calculation, and filling the intermediate
information. It guides you to the final answer. Feel free to put more tables or calculation in the
excel sheet if necessary for your solution.

Question 1: Project Valuation

After extensive research and development, Goodweek Tires, Inc., has recently developed a new
tire, the SuperTread, and must decide whether to make the investment necessary to produce
and market it. The tire would be ideal for drivers doing a large amount of wet weather and off-
road driving in addition to normal freeway usage. The research and development costs so far
have totaled about $10 million. The SuperTread would be put on the market beginning this
year, and Goodweek expects it to stay on the market for a total of four years. Test marketing
costing $5 million has shown that there is a significant market for a SuperTread-type tire.

As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to
evaluate the SuperTread project and provide a recommendation on whether to go ahead with
the investment. Except for the initial investment that will occur immediately, assume all cash
flows will occur at year-end.

Goodweek must initially invest $160 million in production equipment to make the SuperTread.
This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell
the SuperTread to two distinct markets:

1. The original equipment manufacturer (OEM) market: The OEM market consists primarily
of the large automobile companies (like General Motors) that buy tires for new cars. In the
OEM market, the SuperTread is expected to sell for $41 per tire. The variable cost to produce
each tire is $29.

2. The replacement market: The replacement market consists of all tires purchased after the
automobile has left the factory. This market allows higher margins; Goodweek expects to sell
the SuperTread for $62 per tire there. Variable costs are the same as in the OEM market.

Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will
also increase at 1 percent above the inflation rate. In addition, the SuperTread project will incur
$43 million in marketing and general administration costs the first year.

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AFIN 102 Group Assignment Session 2, 2017

This cost is expected to increase at the inflation rate in the subsequent years. Goodweeks
corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent.
The company uses a 13.4 percent discount rate to evaluate new product decisions. Automotive
industry analysts expect automobile manufacturers to produce 6.2 million new cars this year
and production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the
spare tires are undersized and are in a different category). Goodweek Tires expects the
SuperTread to capture 11 percent of the OEM market.

Industry analysts estimate that the replacement tire market size will be 32 million tires this year
and that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8
percent market share.

The appropriate depreciation schedule for the equipment is the seven-year straight-line
depreciation schedule. The immediate initial working capital requirement is $9 million.
Thereafter, the net working capital requirements will be 15 percent of sales. What are the NPV,
payback period, discounted payback period, IRR, and PI on this project? (8 marks)

Question 2: Stock Valuation

Larissa has been talking with the companys directors about the future of East Coast Yachts.
To this point, the company has used outside suppliers for various key components of the
companys yachts, including engines. Larissa has decided that East Coast Yachts should
consider the purchase of an engine manufacturer to allow East Coast Yachts to better integrate
its supply chain and get more control over engine features. After investigating several possible
companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility. She has
asked Dan Ervin to analyze Ragans value.

Ragan Engines, Inc., was founded nine years ago by a brother and sisterCarrington and
Genevieve Raganand has remained a privately owned company. The company manufactures
marine engines for a variety of applications. Ragan has experienced rapid growth because of a
proprietary technology that increases the fuel efficiency of its engines with very little sacrifice
in performance. The company is equally owned by Carrington and Genevieve. The original
agreement between the siblings gave each 150,000 shares of stock.

Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan
has gathered the following information about some of Ragans competitors that are publicly
traded:
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AFIN 102 Group Assignment Session 2, 2017

EPS DPS Stock Price ROE R

Blue Ribband Motors Corp. $1.19 $0.19 $16.32 10.00% 12.00%

Bon Voyage Marine, Inc. $1.26 $0.55 $13.94 12.00% 17.00%

Nautilus Marine Engines -$0.27 $0.57 $23.97 N/A 16.00%

Industry average $0.73 $0.44 $18.08 11.00% 15.00%

Nautilus Marine Enginess negative earnings per share (EPS) were the result of an accounting
write-off last year. Without the write-off, EPS for the company would have been $2.07. Last
year, Ragan had an EPS of $5.35 and paid a dividend to Carrington and Genevieve of $320,000
each. The company also had a return on equity of 21 percent.

Larissa tells Dan that a required return for Ragan of 18 percent is appropriate.

a) Assuming the company continues its current growth rate, what is the value per share of the
companys stock? (1 mark)

b) Dan has examined the companys financial statements, as well as examining those of its
competitors. Although Ragan currently has a technological advantage, Dans research indicates
that Ragans competitors are investigating other methods to improve efficiency. Given this,
Dan believes that Ragans technological advantage will last only for the next five years. After
that period, the companys growth will likely slow to the industry average. Additionally, Dan
believes that the required return the company uses is too high. He believes the industry average
required return is more appropriate. Under Dans assumptions, what is the estimated stock price?
(1 mark)

c) What is the industry average priceearnings ratio? What is Ragans priceearnings ratio?
Comment on any differences and explain why they may exist. (1 mark)

d) Assume the companys growth rate declines to the industry average after five years. What
percentage of the stocks value is attributable to growth opportunities? (1 mark)

e) Assume the companys growth rate slows to the industry average in five years. What future
return on equity does this imply? (1 mark)

f) Carrington and Genevieve are not sure if they should sell the company. If they do not sell
the company outright to East Coast Yachts, they would like to try and increase the value of the
companys stock. In this case, they want to retain control of the company and do not want to
sell stock to outside investors. They also feel that the companys debt is at a manageable level

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AFIN 102 Group Assignment Session 2, 2017

and do not want to borrow more money. What steps can they take to try and increase the price
of the stock? Are there any conditions under which this strategy would not increase the stock
price? (1 mark)

Question 3: The Fama-French Multifactor Model and Mutual Fund Returns

Dawn Browne, an investment broker, has been approached by client Jack Thomas about the
risk of his investments. Dawn has recently read several articles concerning the risk factors that
can potentially affect asset returns, and she has decided to examine Jacks mutual fund holdings.
Jack is currently invested in the Fidelity Magellan Fund (FMAGX), the Fidelity Low-Priced
Stock Fund (FLPSX), and the Baron Small Cap Fund (BSCFX).

Dawn would like to estimate the well-known multifactor model proposed by Eugene Fama and
Ken French to determine the risk of each mutual fund. Here is the regression equation for the
multifactor model she proposes to use:

= + 1( ) + 2 ( ) + 3 ( ) +

In the regression equation, is the return on Asset i at Time t, is the risk-free rate at Time
t , and is the return on the market at Time t. Thus, the first risk factor in the FamaFrench
regression is the market factor often used with the CAPM.

The second risk factor, SMB, or small minus big, is calculated by taking the difference in
the returns on a portfolio of small-cap stocks and a portfolio of big-cap stocks. This factor is
intended to pick up the so-called small firm effect. Similarly, the third factor, HML, or high
minus low, is calculated by taking the difference in the returns between a portfolio of value
stocks and a portfolio of growth stocks. Stocks with low market-to-book ratios are classified
as value stocks and vice versa for growth stocks. This factor is included because of the
historical tendency for value stocks to earn a higher return.

In models such as the one Dawn is considering, the alpha () term is of particular interest. It is
the regression intercept; but more important, it is also the excess return the asset earned. In
other words, if the alpha is positive, the asset earned a return greater than it should have given
its level of risk; if the alpha is negative, the asset earned a return lower than it should have
given its level of risk. This measure is called Jensens alpha, and it is a very widely used tool
for mutual fund evaluation.

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AFIN 102 Group Assignment Session 2, 2017

a) For a large-company stock mutual fund, would you expect the betas to be positive or
negative for each of the factors in a FamaFrench multifactor model? (1 mark)

b) The FamaFrench factors and risk-free rates are available at Ken Frenchs website:
www.dartmouth.edu/~kfrench . Download the monthly factors and save the most recent 60
months for each factor. The historical prices for each of the mutual funds can be found on
various websites, including finance.yahoo.com. Find the prices of each mutual fund for the
same time as the FamaFrench factors and calculate the returns for each month. Be sure to
include dividends. For each mutual fund, estimate the multifactor regression equation using the
FamaFrench factors. How well do the regression estimates explain the variation in the return
of each mutual fund? (2 marks)

c) What do you observe about the beta coefficients for the different mutual funds? Comment
on any similarities or differences. (1 mark)

d) If the market is efficient, what value would you expect for alpha? Do your estimates support
market efficiency? (1 mark)

e) Which fund has performed best considering its risk? Why? (1 mark)

Administrative requirements

This report is worth 20% of the course's marks. Please submit both your report and the excel
file supporting your report.

You should form a group of 2-4 members from any class. You may not make a group of more
than 4 or less than 2. Each group member must contribute substantially to the final submitted
work. Groups can be amongst students from any class.

Your group must elect a leader. The team leader is expected to maintain a weekly journal,
registering the contribution of each team member during the week. The journal must be
submitted with the assignment. It need not be exhaustive, just a record of significant
contributions. All group members are equally responsible for the entire submitted assignment.

You can choose your own group members. You can eject non-contributing members from your
group, but this must be done at least 10 calendar days before submission and you must tell the
group member, preferably by email using your MQ email accounts, that theyre ejected at this

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AFIN 102 Group Assignment Session 2, 2017

time so they can begin the work themselves. The ejected group members may not use the old
groups work that they did not contribute to.

The limit is 10 pages using 1.5 line spacing and default margins, just like this page. Supporting
images, graphs, tables and so on should be placed in-text next to the paragraph where the figure
is discussed. There's no need for an appendix and if you have one it's not likely to be marked.
You may use any common referencing style you like. Bibliographies are not included in the
page count. Items listed in the bibliography but not actually referred to in the report will have
marks deducted.

The assignment should be submitted in electronic form to Turnitin which will be made
available as a link online.

Assignments that are not proof-read will be marked down. Grammar and sentence structure is
important. Business writing should be clear, succinct and front-focused, which means putting
the most important points at the very start.

Answer the questions in the order that they are asked. Be sure to include sub-headings that
contain the question number.

There's no need for an introduction or conclusion. This assignment is a collection of short

answer questions.

There's no need to write the whole question in your assignment if you're struggling to fit
everything into the page limit. You may write the question number as a subtitle to show where
each question begins. For example:

Question 1: Write answer here.