PART 1: PROBLEM SOLVING QUESTIONS

TOTAL MARKS: 30 MARKS

DUE DATE: 4TH JUNE 2020

1. Assume that it is now January 1 2003, and you will need $1000 on January 1, 2007. Your bank
compounds interest at an 8% annual rate.

a) How much must you deposit on Jan 1 2004 to have a balance of $1000 on Jan 1 2007? 2
marks
b) If you want to make equal payments on each Jan 1 from 2004 through 2007 to accumulate
the $1000 how large must each of the four payments be?2 marks
c) If your father were to offer either to make the payments calculated in part b or to give you a
lump sum of $750 on January 1, 2004, which one would you choose?2 marks
d) If you only have $750 on Jan 1 2004, what interest rate compounded annually would you
have to earn to have the necessary $1000 on Jan 1, 2007? 2 marks
e) Suppose you can deposit only $ 186.29, each Jan 1 from 2004 through 2007 but you still
need $1000 on Jan 1 2007, what interest rate with annual compounding must you seek out
to achieve your goal? 2 marks
f) To help you reach your $1000 goal, your father offers to give you $400 on Jan 1 2004. You
will get a part time job and make six additional payments of equal amounts, each six months
thereafter. If all of his money is deposited in a bank that pays 8% compounded semi-
annually how large must each of the six payments be? 2 marks
g) What is the effective annual rate being paid by the bank in part f? 3 marks

FV 1000
a) PV = n= = $ 793.8
( 1+i ) (1+0.08)3
FV 1000
b) CF = (1+ r) −1 = (1+ 0.08)4−1 = $ 221.9
n

r 0.08
c) FV = PV (1+r ) = 750(1+0.08)3 = $ 944.8
n

d) 1000 = 750(1+r )3= 10.06%

( 1+r )4 −1
e) 1000 = 186.29 ( r )
= 20%

f) FV 6=PV (1+i)6 = 400(1+0.04)6 = $ 506.12

 = $(1000-506.12) = $ 493.88
493.88
CF = ( 1+0.04 )6 −1 = $ 74.5
( 0.04 )
I NOM M
g) EFF = (1+ ) −1
M
0.08 2
=(1+ ) −1
2
=1.0816 – 1 = 8.16%

2. LEI has the following capital structure, which it considers to be optimal:

Debt 25%, preferred stock 15%, common equity 60%

LEI expected net income this year is $ 34285.72. Its established dividend pay-out ratio is 30%, its
federal plus state tax is 40% and investors expect earnings and dividends to grow at a rate of 9%
constant in the future. LEI paid a dividend of $3.60 per share last year, and its stocks currently
sells at a price of $54 per share.

LEI can obtain new capital in the following ways:

New preferred stock with a dividend of $ 11 can be sold to the public at price of $95 per share.
New debt can be sold at an interest rate of 12%.

A) Determine the cost of each capital structure component. 2.5 MARKS

B) Calculate the WACC. 2.5 MARKS

C) LEI has the following investment opportunities that are typical average risk projects for the
firm

Project Cost at t=0 Rate of Return

$10000 17.4%

$20000 16.0%
$10000 14.2%
 $20000 13.7%

$10000 12.0%

Which project should LEI accept? Why? 2 marks

A. (Debt) r i=¿ r ¿ ( 1−T )=¿ 12% (1-0.04)= 7.20%
d

D1 3.60(1+0.09)
(Common Stock)r s= +g = +0.09 = 16.27%
P0 54

D p 11
(Preferred Stock) r p = = =¿ 11.58%
N p 95

B. WACC = w i r i (1-T) + w p r p + w s r s
=0.25(7.20%) + 0.15(11.58%) + 0.60(16.27%) = 13.3%

C. LEI should accept Project A, B, C, D. The project E should be rejected because the rate of return
is lower than the WACC.

3. Your broker offers to sell you some shares of Bahsen and Co. common stock that paid you a
dividend of $2 yesterday (D0). You expect the dividend to grow at a rate of 5% per year for the
next three years and if you buy the stock you plan to hold it for 3 years and then sell it.

a) Find the expected dividend for each of the next three years. 1 mark

b) Given that the appropriate discount rate is 12% and that the first of these dividend payments
will occur 1 year from now. Find the present value of the dividend stream. 1 mark

c) You expect the price of the stock 3 years from now to be $ 34.73 that is you expect P3 to
equal $34.73 discounted at a 12% rate. What is the present value of this expected future stock
price? 2 marks

d) If you plan to but the stock and hold it for three years and then sell it for $34.73 what is the
most you should pay for it today?2 marks

e) Calculate the present value of the stock assuming that g=5% and it is constant. 2 marks
a ¿ D1 = 2(1+0.05) = $2.1, D 2 = 2(1+0.05)2 =$2.205, D3=2(1+0.05)3 = $2.32

2.1 2.205 2.205

b) PV of dividend stream = + + = $5.28
(1.12) (1.12)2 (1.12)3

34.73
c) PV = (( )
1.12 )3
= $24.72

d) Money that should be paid = $(5.28 + 24.72) = $30

D1 2.1
e) P0 = = = $30
r d −g (0.12−0.05)