Posted: February 27th, 2023

problem set

Managerial Finance – First Bi Term

Problem Set #6

Petersen & Peterson Company is a 6-year-old company founded by Jackson Peterson and Mary Peterson to exploit metamaterial plasmonic technology to develop and manufacture miniature microwave frequency directional transmitters and receivers for use in mobile Internet and communications applications. The technology, although highly advanced, is relatively inexpensive to implement and their patented manufacturing techniques require little capital in comparison to many electronic fabrication ventures. Because of the low capital requirement, Jackson and Mary have been able to avoid issuing new stock and thus own all of the shares. Because of the explosion in demand for its mobile Internet applications, the company must now access outside equity capital to fund its growth and the couples have decided to take the company public. Until now, Jackson and Mary have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue.

However, before talking with potential outside investors, they must decide on a dividend policy. Your supervisor at the consulting firm Ernst Young & Associates, which has been retained to help the company prepare for its initial public offering, has asked you to make a presentation to Jackson and Mary in which you plan to review the theories of dividend policy and discuss capital structure decisions.

a. Explain to the Petersons the term a “distribution policy”?

b. Describe the following theories of dividend payout preferences and how they will affect dividend policy of Peterson & Peterson Company:

i. dividend irrelevance theory

ii. bird-in-the-hand theory

iii. tax effect theory, and

iv. information content hypothesis (signaling theory)

Peterson & Peterson Company plans to undertake a massive capital expansion project next year that will require $10 million investment. The company’s target capital structure consists of 60% debt and 40% equity. Peterson has 1million shares of stock outstanding. If net income next year is

$6 million and the company follows a residual distribution policy with all distributions as dividends, determine the following:

c. the company’s dividend per share for next year

d. the company’s forecasted dividend payout ratio

e. the amount of equity financing and long-term debt needed to finance the project

f. What are the advantages and disadvantages of the company’s residual policy? (Hint: do not neglect signaling and clientele effects.)

g. Peterson Company plans to repurchase some of its own outstanding stock in the future if it sees that its stock price is undervalued in the market and more specially to reorganize its capital structure. Identify 
three advantages and 
three disadvantages of stock repurchases.

Boehm Corporation produces satellite earth stations that sell for $150,000 each. The firm’s fixed costs are $1.5 million, 20 earth stations are produced and sold each year. Profits are $400,000 and the firm’s assets (all equity financed) are $5million. Due to technological advances in the industry the firm estimates that it can change its production process by adding $10 million to assets and

$500,000 to fixed operating costs. This change will reduce variable costs per unit by $5,000 and increase output by 30 units. However, the sales price on all units must be lowered to $140,000 to permit sales of the additional units. Boehm Corporation has tax carryforwards that render its tax rate zero, its cost of equity is 18% and it has no debt in its capital structure. Thus, the company’s profit is equal to earnings before interest and taxes (EBIT)

h. Determine the company’s variable cost per unit and break-even quantity under the initial plan.

i. Determine the company’s variable cost per unit and break-even quantity under the proposed plan.

j. Would the new proposed plan expose the firm to more or less business risk than the initial plan. Show your work.

Submit your answers in a Word document.

Managerial Finance – Full Term

Problem Set #6

The management of

Ark Industries

wants to analyze the performance of the company’s stock in the stock market. They want to compare the stock performance with Apex Inc, a strong competitor in the industry, and the market index. The following data is available for managerial finance analysis.

Capital gain/loss

Dividend

$2.23

*Capital gain = difference between ending price and beginning price

1.    Use the data given to calculate the annual returns for Ark Industries, and Apex Inc during the 5-year period.

2.    Calculate the historical average returns for Ark Industries, Apex Inc., and the market index during the 5-year period.

3.     Calculate the standard deviation of the returns for Ark Industries.

4.   Ark Industries Inc. wants to estimate its beta. The following information is available:

i. Calculate the beta for Ark Industries.

ii. If Ark Industries’ beta were 2.0, then what would be its new required rate of return?

5. An individual investor, James Bond needs an extra return of 6.0% before he will take on the stock market’s risk to invest in Ark Industries. If the risk-free rate on long-term Treasury bonds is 5.0%. what would be the required return on the market?

6. James Bond wants to determine the required rate of return on two stocks (stock A and stock B) that he just added to his portfolio. The following information is available:

Market rate of return = 11.0%

Risk free rate =5.0%

Beta for stock A=

0.7

7

Beta for stock B = 0.99

Use the Security Market Line (SML) equation to calculate the required rate of return for stock A and stock B.

7.   Richard Morgan, another individual investor wants to purchase four stocks for his portfolio.  The expected return, portfolio weights, and the betas of the stocks are given below:

30%

20%

i. Calculate the portfolio beta.

ii. Calculate the portfolio’s required rate of return.

8. Efficient Markets Hypothesis (EMH) holds that security prices adjust quickly to new intrinsic value as soon as new information becomes available. Distinguish among the 

three
 forms of the EMH.

9.  A new body of evidence is emerging in the field of behavioral finance which shows that investors often behave irrationally, but in predictable ways. Explain the following biases that affect the rationality of people’s decision-making process:

i.   overconfidence

ii.   self-attribution bias

iii.    herding        

10. The Fama-French three-factor model predicts stock’s return given the return of the market, the SMB portfolio, and the HML portfolio. The model is given as:

Predicted return = ai + bi (r M,t) + ci (r SMB,t) + di (r HML,t). 

You have estimated that ai = 0, bi = 1.2, ci = -0.4, and di =1.3. On May 1, the market return (rM,t), was 10%, the return on the SMB portfolio (rSMB) was 3.2%, and the return on the HML portfolio (rHML) was 4.8%.

 i.  using the model, predict the stock’s return for the month of May 1.

 ii. if the actual return of the stock is 17.5% on May 1, calculate the unexplained return of the stock.

Submit your answers in a Word document.