Part I, question 1



Part I

Question 1

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Since the project concerns investing in natural gas wells which is Superior Oil's line of business-Superior Oil is a major natural gas producer- , we expect the beta of the new project to be the same as Superior Oil's beta. That is, our estimation of the project's beta is 0.75. Therefore, the projects NPV should be discounted at 18%, regardless of which firm takes on the project. Since the NPV is positive at 18% which is an appropriate rate for a project with beta=0.75, both firms should proceed.

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Even though the new project has a negative NPV at Dow's required rate of return, the project should not be estimated at that return, rather at the projects required rate of return which is 18%.

Question 2

a) Projects C and D have a higher expected return than the firm’s cost of capital.

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Firm’s Cost of Capital = 0.08+ (0.15-0.08)*1 = 0.15 = 15%

Project A = 12% < 15%

Project B = 13% < 15%

Project C = 18% > 15%

Project D = 19% > 15%

b) Project A and C should be accepted because it plots above the SML line.

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c) Project A should be rejected incorrectly because it plots below the hurdle rate Rc as shown in graph in part (b).

Project D should be accepted incorrectly because it plots above the hurdle rate Rc as shown in graph in part (b).

Question 3

Indicate whether the following statement is True, False, or Uncertain and explain why. (If this were an exam question, credit for your answer would depend entirely on the quality of your explanation.):

A risky security cannot have an expected return that is less than the risk-free rate because no risk-averse investor would be willing to hold this asset in equilibrium

True. The Capital Asset Pricing Model (CAPM) says that the expected return of a risky security equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return then the investment should not be undertaken.

Expected Return = Risk free rate + Beta of the security (Expected market return – Risk free

rate)

E(ri) = Rf + (i {E(rm) - Rf} = Rf + (i (MRP)

Question 4

Would you expect the sequence of price changes to follow a similar pattern? Why or why not?

No, we would not expect the sequence of price changes to follow a similar pattern. This opinion is based on the weak form of the efficient market hypothesis. In this form it is believed that all information contained in past price movements is fully reflected in current market prices. In other words, the good or bad news would already be reflected in the price of the stock and there is no way to predict future market trends based on past trends. However, if some news were to come out, let’s call it bad news (i.e. beloved CEO dies of heart attack) then the price of the stock may drop. But there is no way to predict such things and in no way that such events could be positively correlated with future independent events.

Part II

Question 1

Should Eurika re-open the mine, or sell the land for $1.5 million now?

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Mistakes we found in the University of Georgia file:

• Sales should be $9 million per year, instead of $8 million. This was found by multiplying production by the given price.

• Equipment salvage value was not included in the UGA file. We added a $1 million cash flow to the last year to account for the salvage value of the equipment.

• Depreciation is not accounted for after net income was calculated, so we added depreciation back to net income to determine the net cash flow.

• Depreciation was done on a straight-line method, whereas it should be done using the MACRS method (as stated in the problem statement). We used the given values in BE on pg. 388 to calculate the depreciation schedule.

• The fixed cost of operating the furnace was included in the cost evaluation, but should not be, since Eurika is going to produce platinum anyway, this cost is a sunk cost, meaning it will be incurred regardless.

• The proper discount rate was not used for determining the NPV, UGA used the market rate of 12%, but the appropriate rate is the firm's cost of capital, which is 3%, calculated by using the firm's beta.

Conclusion:

Since the NPV is $20,453 (thousand), it is much more valuable to operate rather than to sell the mine for $1.5 million.

Question 2

What would you advise Eurika to do if it were operating with a debt-equity ratio of 1.0 and the debt's interest rate was the riskless rate?

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They should still re-open the mine. The only assets of the firm are $5 million in equipment, so the debt is $2.5 million. The interest payments do not lower the NPV below $1.5 million.

Question 3

Return to the assumption that Eurika is an all-equity firm. What would you advise Eurika to do if inflation were forecasted to be 20% per year over the coming five years?

|c) | | | | |

| |C|

| |a|

| |s|

| |h|

| |f|

| |l|

| |o|

| |w|

| |s|

| |:|

Which cash flows in the accompanying table change?

We assumed that sales and direct costs would change, but equipment, geo study, depreciation, and the furnace would remain unchanged. We assumed sales would have to increase by the rate of inflation, because if you knew the rate of inflation you would adjust your prices accordingly. As would your suppliers assuming they knew the rate of inflation as well, thus driving up your costs. If this were the case all of your variable costs would increase by the rate of inflation (including labor, raw materials, utilities, etc.). Depreciation would not change, because it is predetermined by the MACRS schedule.

Why does this NPV differ from the value you computed in 1)?

Because although it increases and decreases sales and costs at the same proportional rate, these are not necessarily the same numbers and so the outcome will differ from the original one

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0.75

SML

β

E(ri)

1.25

22%

18%

12%

New project

Superior Oil

Dow

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