Introduction to Finance

(FIN215)

Fall 2017-2018

Assignment

Submitted to

Dr.Suchi Dubey

Submitted to

Mohamed Naser Almazrouei

201620059
Ques. 1 Using the data in the following table, estimate

a) the average return and volatility for each stock,

b) the covariance between the stocks, and
c) the correlation between these two stocks

Year 2004 2005 2006 2007 2008 2009

Stock A -10% 20% 5% -5% 2% 9%
Stock B 21% 7% 30% -3% -8% 25%

Answer

a)

−10 + 20 + 5 − 5 + 2 + 9
̅A =
R = 3.5%
6
21 + 7 + 30 − 3 − 8 + 25
̅B =
R = 12%
6
1
Variance of A = [(−0.1 − 0.035)2 + (0.2 − 0.08)2 + (0.05 − 0.035)2 + (−0.05 − 0.035)2
5
+ (0.02 − 0.035)2 + (0.09 − 0.035)2 ] = 0.01123

Volatility of A = SD(R A ) = √variance of A = √0.01123 = 10.60%

1
Variance of B = [(0.21 − 0.12)2 + (0.3 − 0.12)2 + (0.07 − 0.12)2 + (0.03 − 0.12)2
5
+ (−0.08 − 0.12)2 + (0.25 − 0.12)2 ] = 0.02448

Volatility of B = SD(R B ) = √variance of B = √0.02448 = 15.65%

b)

1
Covariance = [(−0.1 − 0.035)(0.21 − 0.12) + (0.2 − 0.035)(0.3 − 0.12)
5
+ (0.05 − 0.035)(0.07 − 0.12) + (−0.05 − 0.035)(−0.03 − 0.12)
+ (0.02 − 0.035)(−0.08 − 0.12) + (0.09 − 0.035)(0.25 − 0.12)] = 0.104%

c)

Covariance
Correlation = = 6.27%
6SD(R A )SD(R B )
Ques. 2 Suppose you have $100,000 in cash, and you decide to borrow another $15,000 at a
4% interest rate to invest in the stock market. You invest the entire $115,000 in a portfolio
J with a 15% expected return and a 25% volatility.

a. What is the expected return and volatility (standard deviation) of your investment?
b. What is your realized return if J goes up 25% over the year?
c. What return do you realize if J falls by 20% over the year?

Answer

a)

115,000
X= = 1.15
100,000

E[R] = rf + x(E[R j ] − r) = 4% + 1.15(11%) = 16.65%

Volatility = x SD[R j ] = 1.15(25%) = 28.75%

b)

115,000(1.25) − 15,000(1.04)
R= − 1 = 28.15%
100,000

c)

115,000(0.80) − 15,000(1.04)
R= − 1 = −23.6%
100,000
Ques. 3 Harrison Holdings, Inc. (HHI) is publicly traded, with a current share price of $32
per share. HHI has 20 million shares outstanding, as well as $64 million in debt. The
founder of HHI, Harry Harrison, made his fortune in the fast food business. He sold off
part of his fast-food empire, and purchased a professional hockey team. HHI’s only assets
are the hockey team, together with 50% of the outstanding shares of Harry’s Hotdogs
restaurant chain. Harry’s Hotdogs (HDG) has a market capitalization of $850 million, and
an enterprise value of $1.05 billion. After a little research, you find that the average asset
beta of other fast-food restaurant chains is 0.75. You also find that the debt of HHI and
HDG is highly rated, and so you decide to estimate the beta of both firms’ debt as zero.
Finally, you do a regression analysis on HHI’s historical stock returns in comparison to the
S&P 500, and estimate an equity beta of 1.33. Given this information, estimate the beta of
HHI’s investment in the hockey team.

Answer

HHI Equity = 32  20 = $640

HHI debt = $64

HHI asset beta = (640/ (640+64)) 1.33 + (64/ (640+64)) 0 = 1.21

Holdings of Hotdogs = 850/2 = 425

Value of Hockey Team = (640+64) - 425 = $279

Hotdog equity beta: (850/1050)  βE + (200/1050)  0 = 0.75

βE = 0.75  1050/850 = 0.93 for hotdog equity

So, if β = hockey team beta, (425/(425+279)) 0.93 + (279/(425+279))  β = 1.21 β = 1.64 Beta
of hockey team = 1.64
Ques. 4 You own a firm with a single new product that is about to be introduced to the
public for the first time. Your marketing analysis suggests that the demand for this product
could be anywhere between 500,000 units and 5,000,000 units. Given such a wide range,
discuss the safest cost structure alternative for your firm

Answer

Since there is a great deal of variability concerning the demand for the product, then the safest

alternative would be to create a cost structure that limits the variability of the firm’s EBIT. This

means that you would create a cost structure that is composed of high unit variable costs with

low fixed costs. Although this would not enable the firm to maximize earnings if the 5,000,000

unit forecast occurs, it limits the downside profitability for the firm in the event that the 500,000

unit forecast occurs.

Ques. 5 One year ago, your company purchased a machine used in manufacturing for
$110,000. You have learned that a new machine is available that offers many advantages;
you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over
10 years, after which it has no salvage value. You expect that the new machine will produce
EBITDA (earning before interest, taxes, depreciation, and amortization) of $40,000 per
year for the next 10 years. The current machine is expected to produce EBITDA of $20,000
per year. The current machine is being depreciated on a straight-line basis over a useful life
of 11 years, after which it will have no salvage value, so depreciation expense for the
current machine is $10,000 per year. All other expenses of the two machines are identical.
The market value today of the current machine is $50,000. Your company’s tax rate is
45%, and the opportunity cost of capital for this type of equipment is 10%. Is it profitable
to replace the year-old machine?

Answer

Replacing the machine increases EBITDA by 40,000 - 20,000 = 20,000.

Depreciation expenses rises by $15,000 - $10,000 = $5,000.

Therefore, FCF will increase by (20,000) × (1 - 0.45) + (0.45)(5,000) = $13,250 in years 1

through 10.

In year 0, the initial cost of the machine is $150,000.

Because the current machine has a book value of $110,000 - 10,000 (one year of depreciation) =
$100,000, selling it for $50,000 generates a capital gain of 50,000 - 100,000 = -50,000.

This loss produces tax savings of 0.45 × 50,000 = $22,500, so that the after-tax proceeds from
the sales including this tax savings is $72,500.

Thus, the FCF in year 0 from replacement is -150,000 + 72,500 = -$77,500.

NPV of replacement = -77,500 + 13,250 × (1/0.10)(1 - 1/1.1010) = $3,916.

There is a small profit from replacing the machine. Even though the decision has no impact on
revenues, it still matters for cash flows because it reduces costs. Further, both selling the old
machine and buying the new machine involve cash flows with tax implication
Ques. 6 Chip’s Home Brew Whiskey forecasts that if the firm sells each bottle of Snake-
Bite for $20, then the demand for the product will be 15,000 bottles per year, whereas sales
will be 90 percent as high if the price is raised 10 percent. Chip’s variable cost per bottle is
$10, and the total fixed cash cost for the year is $100,000. Depreciation and amortization
charges are $20,000, and the firm has a 30 percent marginal tax rate. Management
anticipates an increased working capital need of $3,000 for the year. What will be the effect
of a price increase on the firm’s FCF for the year?

Answer

For Current price

Revenue = 15000 x $20 = $300000
Variable costs = 15,000 x $10 = $150000
Fixed cost = $100000 , Depreciation = $20000
Income before tax = $300000 - $150000 - $100000 - $20000 = $30000
Tax = 30% of $30000 = $9000
Operating income = $30000 - $9000 = $21000
Operating cash flow = $21000 + $20000 (Depreciation) = $41000
Since there are no capital expenditures, FCF = $41000
For the new price
Revenue = 86% of $15000 x ($20 + 12% of $20) = $288960
Variable costs = 86% of 15,000 x $10 = $129000
Fixed cost = $100000
Depreciation = $20000
Income before tax = $288960 - $129000 - $100000 - $20000 = $39960
Tax = 30% of $39960 = $11988
Operating income = $39960 - $11988 = $27972
Operating cash flow = $27972 + $20000 (Depreciation) = $47972
Working capital = $3000
FCF = $47972 - $3000 = $44972
Ques 7 Calculate the weighted average cost of capital for a firm, explain the limitations of
using a firm’s weighted average cost of capital as the discount rate when evaluating a
project, and discuss the alternatives to the firm’s weighted average cost of capital that are
available.

Answer

Using the WACC in Practice

 The after-tax version of the formula for the weighted-average cost of capital is:

WACC  xDebt kDebt pretax (1  t )  xps kps  xcs kcs .

 The financial analyst should use market values rather than book values to calculate

WACC.

A. Limitations of WACC as a Discount Rate for Evaluating Projects

 Financial theory tells us that the rate that should be used to discount these incremental

cash flows is the rate that reflects their systematic risk.

 This means that the WACC is going to be the appropriate discount rate for evaluating a

project only when the project has cash flows with systematic risks that are exactly the

same as those for the firm as a whole.

o When a single rate, such as the WACC, is used to discount cash flows for

projects with varying levels of risk, the discount rate will be too low in some

cases and too high in others.

o When the discount rate is too low, the firm runs the risk of accepting a negative-

NPV project.

 The estimated NPV will be positive even though the true NPV is

negative.

o When the discount rate is too high, the firm runs the risk of rejecting a positive-

NPV project.
  The estimated NPV will be negative even though the true NPV is

positive.

 The key point is that it is correct to use a firm’s WACC to discount the cash flows for a

project only if the following conditions hold.

o Condition 1: A firm’s WACC should be used to evaluate the cash flows for a

new project only if the level of systematic risk for that project is the same as that

for the portfolio of projects that currently comprise the firm.

o Condition 2: A firm’s WACC should be used to evaluate a project only if that

project uses the same financing mix—the same proportions of debt, preferred

shares, and common shares—used to finance the firm as a whole.

B. Alternatives to Using WACC for Evaluating Projects

 If the discount rate for a project cannot be estimated directly, a financial analyst might try

to find a public firm that is in a business that is similar to the project.

o This public company would be what financial analysts call a pure-play

comparable because it is exactly like the project.

o This approach is generally not feasible due to the difficulty of finding a public

firm that is only in the business represented by the project.

 Financial managers sometimes classify projects into categories based on their systematic

risks.

o They then specify a discount rate that is to be used to discount the cash flows for

all projects within each category.