8-2



8-2

Suppose that a thirty-year U.S. Treasury bond offers a 4 percent coupon rate, paid semiannually. The market price of the bond is $1,000, equal to its par value.

a. What is the payback period for this bond?

b. With such a long payback period, is the bond a bad investment?

c. What is the discounted payback period for the bond, assuming its 4 percent coupon rate is the required return? What general principle does the example illustrate regarding a project’s life, its discounted payback period, and its NPV?

a. Payback on this bond is 25 years. You pay $1,000. You receive $40 a year for 25 years, a total of $1,000.

b. The bond is not necessarily a bad investment. Payback does not take time value of money into account, nor does it account for cash flows received after the payback period. It is more appropriate to calculate the NPV of an investment. Given the risk level of the bond, is 4% a fair return? If the answer is yes, then the bond may be a good investment.

c. The discounted payback, using a 4% discount rate, is 30 years. This shows that unless the acceptable payback period is decreased when discounted payback is used, vs. regular payback, then projects which return money late in the life of the investment are even more disadvantaged under discounted payback than under regular payback. NPV is a more appropriate method to use to determine the value of an investment project.

8-9

For each of the projects shows in the following table, calculate the internal rate of return (IRR).

Project A Project B Project C Project D

Initial Cash

Outflow (CF0) $72,000 $440,000 $18,000 $215,000

Year (t) Cash Inflows (CF1)

1 $16,000 $135,000 $7,000 $108,000

2 20,000 135,000 7,000 90,000

3 24,000 135,000 7,000 72,000

4 28,000 135,000 7,000 54,000

5 32,000 --------- 7,000 ---------

|  |Project A |Project B |Project C |Project D |

|Initial Cash Flow |($72,000) |($440,000) |($18,000) |($215,000) |

|1 |$16,000 |$135,000 |$7,000 |$108,000 |

|2 |$20,000 |$135,000 |$7,000 |$90,000 |

|3 |$24,000 |$135,000 |$7,000 |$72,000 |

|4 |$28,000 |$135,000 |$7,000 |$54,000 |

|5 |$32,000 |  |$7,000 |  |

|IRR |17.4% |8.7% |27.2% |21.4% |

Please see the attached excel sheet

10-1a

Intel Corp. (INTC) has a capital structure consisting almost entirely of equity.

If the beta of INTC stock equals 1.6, the risk-free rate equals 6 percent, and the expected return on the market portfolio equals 11 percent, what is INTC’s cost of equity?

Cost of Equity = 6% + [1.6(11%-6%)]

= 14%

10-3

In its 2006 annual report, The Coca-Cola Company reported sales of $24.09 billion for fiscal year 2006 and $23.10 billion for fiscal year 2005. The company also reported operating income (roughly equivalent to EBIT) of $6.31 billion, and $6.09 billion in 2005 and 2006, respectively. Meanwhile, arch-rival PepsiCo, Inc. reported sales of $35.14 billion in 2006 and $32.56 billion in 2005. PepsiCo’s operating profit was $6.44 billion in 2006 and $5.92 billion in 2005. Based on these figures, which company had higher operating leverage?

Pepsico has a higher operating leverage as per the attached excel sheet

|  |Coca-Cola |Pepsi |

|  |2006 |2005 |2006 |2005 |

|Sales |$24.09 |$23.10 |$35.14 |$32.56 |

|Operating income |$6.09 |$6.31 |$6.44 |$5.92 |

|  |  |  |  |  |

|DOL |0.81 |  |1.11 |  |

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