Financial Management II

1. Sometimes preferred stock is referred to as “hybrid equity financing.” Identify and explain the features of preferred stock that give it the designation of “hybrid equity financing.” (4 marks)

2. What are the advantages and disadvantages of using the DCF model for determining the cost equity capital.

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3. Define the term ‘investment risk’. And give an example of a risk-free investment and a risky investment. Explain why an investment might be risk-free and another is very risky. (2 marks)

4. What is meant by diversification? And what benefits can be derived from diversification?

5. The Metrics electronic Company is considering a three-year project to market a device that measures the number of calories used up by athletes based on new technology. A market study indicates a 60% probability that demand will be good and a 40% chance that it will be poor. It will cost $5M to bring the new device to market. Cash flow estimates indicate inflows of $3M per year for three years at full manufacturing capacity if demand is good, but just $1.5M per year if it’s poor. The firm’s cost of capital is 10%.

(I) Analyze the project by developing a decision tree for the project then calculate the project’s expected NPV.

(ii) Should the project be accepted or abandoned?

(iii) What are real options in capital budgeting? Give two examples of the type of options available in capital budgeting.

(iv) Why is the application of real options in capital budgeting is considered to be more effective than just only applying NPV to capital projects?

6. You are an Investment Manager at Pegasus Securities and you are preparing for the next meeting of the investment committee. The committee requested you to assess the capital structure of Industrial Production Ltd a manufacturer of industrial products. The following information is available about the company in assisting you in making your assessment.

(A) Cost of Equity – Suppose stock in Industrial Production Ltd has a beta of .80. The return on the market 12% percent, and the risk-free rate is 6 percent the firm’s last dividend was $1.20 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $45 per share.

Determine the firm’s cost of equity capital using the:

i. SML approach

ii. Dividend growth model

(B) Calculating the WACC

In addition to the information given in (b) above, suppose Industrial Production ltd has a target debt-equity ratio of 50 percent. Its cost of debt is 9 percent, before taxes. If the tax rate is 35 percent.

Determine the company weighted average cost of capital (WACC)

(C) Flotation Costs

Suppose Industrial Production Ltd is seeking $30 million for a new project. The necessary funds will have to be raised externally. The firm’s flotation costs for selling debt and equity are 2 percent and 16 percent, respectively.

i. If flotation costs are considered, what is the true cost of the new project?

ii. If Industrial Production Ltd stock currently sells for $50 per share, and the dividend per share will probably be about $5. A shareholder argues, “It will cost the firm $5 per share to use the stockholders’ money this year, so the cost of equity is equal to 10 percent ($5/50).”

What is wrong with this conclusion?

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