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Chapter 4: Q26BP (page 325)
Question:Analogue Technology has preferred stock outstanding that pays a \(9 annual dividend. It has a price of \)76. What is the required rate of return (yield) on the preferred stock?
Answer
The required rate of return is 11.84%
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Tim Trepid is highly risk-averse while Mike Macho actually enjoys taking a risk.
a. Which one of the four investments should Tim choose? Compute coefficients of variation to help you in your choice.
Investments
Returns:
Expected Value
Standard Deviation
Buy stocks ..................................... \( 9,140 \) 6,140
Buy bonds ..................................... 7,680 2,560
Buy commodity futures ................. 19,100 26,700
Buy options ................................... 17,700 18,200
b. Which one of the four investments should Mike choose?
Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices?
Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilled with the response he had received from drug companies for his latest discovery, a unique electronic stimulator that reduces the pain from arthritis. The process had yet to pass rigorousFederal Drug Administration (FDA) testing and was still in the early stages ofdevelopment, but the interest was intense. He received the three offers described in the following paragraph. (A 10 percent interest rate should be used throughout this analysisunless otherwise specified.)
Offer I\(1,000,000 now plus \)200,000 from year 6 through 15. Also if the productdid over \(100 million in cumulative sales by the end of year 15, he wouldreceive an additional \)3,000,000. Dr. Wolf thought there was a 70 percentprobability this would happen.
Offer IIThirty percent of the buyer鈥檚 gross profit on the product for the next fouryears. The buyer in this case was Zbay Pharmaceutical. Zbay鈥檚 gross profitmargin was 60 percent. Sales in year one were projected to be \(2 millionand then expected to grow by 40 percent per year.
Offer IIIA trust fund would be set up for the next eight years. At the end of thatperiod, Dr. Wolf would receive the proceeds (and discount them back tothe present at 10 percent). The trust fund called for semiannual paymentsfor the next eight years of \)200,000 (a total of $400,000 per year).
The payments would start immediately. Since the payments are coming at thebeginning of each period instead of the end, this is an annuity due. Assumethe annual interest rate on this annuity is 10 percent annually (5 percent semiannually).Determine the present value of the trust fund鈥檚 final value. Hint:See the section on Annuities Due.
Required: Find the present value of each of the three offers and indicatewhich one has the highest present value.
Assume a \(90,000 investment and the following cash flows for two alternatives:
Year | Investment A | Investment B |
1 | \)25,000 | \(40,000 |
2 | 30,000 | 40,000 |
3 | 25,000 | 28,000 |
4 | 19,000 | -- |
5 | 25,000 | -- |
a. Calculate the payback for investments A and B.
b. If the inflow in the fifth year for Investment A was \)25,000,000 instead of $25,000, would your answer change under the payback method?
Question:In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why?(LO11-3)
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