Assignment # 2

Problem 1.
Mater Pasta, Inc., has projected a sales volume of $1,432 for the
second year of a proposed expansion project. Costs normally run 70%
of sales, or about $1,002 in this case. The depreciation expense will be
$80, and the tax rate is 34%. What is the operating cash flow (OCF) in the
second year? Calculate your answer using all the three approaches (topdown, bottom-up, and tax shield approach)
Problem 2.
The Datum Co. has recently completed a $400,000, two year marketing
study. Based on the results of the study, Datum has estimated that 10,000
of its new electro-optical data scanning hardware known as "Commander
Data" could be sold annually over the next eight years at a price of $9500
each. Variable costs per unit are $7400, and fixed costs total $12 million
per year. Start-up costs include $40 million to build production facilities,
$2.4 million for land, and $8 million in net working capital. The $40
million facility will be depreciated on a straight-line basis to a value of
zero over the eight-year life of the project. At the end of the project's life,
the facilities (including the land) will be sold for an estimated $8.4
million;The value of the land is not expected to change during the eight
year period.
Finally, start-up would also entail tax-deductible expenses of $1.4
million at time 0. Datum is an on-going, profitable business and pays taxes
at a 34% rate on all income and capital gains. Datum has a 10%
opportunity cost for projects such as this one.
a. What is the cash flow for the "Commander Data" project for years 1 (time t
= 1) through 7 (time t = 7)?
b. Express the operating cash flows from problem a in terms of the after-tax
revenues, after-tax expenses, and the depreciation tax shield. What is the
marginal contribution to cash flow of each of the three components?
c. What is the time 0 cash flow?
d. What is the time 8 cash flow?
e. Should Datum proceed with the "Commander Data" project?
Problem 3.
(a) Draw the security market line for the case where the market risk
premium is 5% and the risk free rate is 7 %.
(b).Suppose that an asset has a beta of -1 and an expected return of 4%. Plot
it on the graph you drew in part (a). Is the security properly priced. If
not, clearly explain what will happen in this market.

(c). Suppose an asset has a beta of 3 and an expected return of 20%. Plot it on
the graph. Is the security properly priced. If not, clearly explain what
will happen in this market.
Problem 4.
ATT-Pune has 3 million shares of common stock outstanding with
a market price of $4 per share. The firm's outstanding bonds
have 5 years to maturity, a face value of $5 million, a coupon rate
equal to 10.00% and sell at par. The risk free rate is 7%, and the
expected return on the market is 14%. Real Madrid stock has a
beta of 1.2 and the marginal corporate tax rate is 40%. Compute
the weighted average cost of capital.
Problem 5.
Strom, Inc., has 250,000 outstanding shares of stock that sell for
$20 per share. Strom, Inc., currently has no debt. The appropriate
discount rate for the firm is 15%. Strom's earnings last year were
$750,000. Management expects that if no changes affect the assets
of the firm, the earnings will remain $750,000 in perpetuity. Strom
pays no taxes.
Strom plans to buy out a competitor's business at a cost of $300,000.
Once added to Strom's current business, the competitor's facilities will
generate earnings of $120,000 in perpetuity. The competitor has the
same risk as Strom, Inc.
a. Construct the market value balance sheet for Strom before the
announcement of the buyout is made.
b. Suppose Strom uses equity to fund the buyout.
i. According to the Efficient markets Hypothesis, what will happen to
Strom's price?
ii. Construct the market value balance sheet as it will look after the
announcement. (Instead of the typical balance sheet with book values,
the market-value balance sheet shows market values. On the left hand
side you can show items like assets, PV of tax shields, NPV of growth
opportunities, market value of assets in place, etc., and on the right hand
side, market values of items like debt and equity or other liabilities.)
iii. How many shares did Strom sell?
iv. Once Strom sells new shares of stock, how will its balance sheet look?
v. After the purchase is finalized, how will the market value balance sheet
look?

vi. What is the return to Strom's equity holders?

c. Suppose Strom uses 10% debt to fund the buyout.
i. Construct the market value balance sheet as it will look after the
announcement.
ii Once Strom sells the bonds, how will the balance sheet look?
iii What is the cost of equity?
iv. Explain any differences in the cost of equity between the two plans.
v. Use MM Proposition II to verify the answer in (iii).
d. Under each financing plan, what is the price of Strom stock after the
buyout?