P8–14 Portfolio analysis

You have been given the expected return data shown in the first table on three assets—F, G, and H—over the period 2013–2016.

Expected return

Year Asset F Asset G Asset H

2013 16% 17% 14%

2014 17 16 15

2015 18 15 16

2016 19 14 17

Using these assets, you have isolated the three investment alternatives shown in the following table.

Alternative Investment

1) 100% of asset F

2 )50% of asset F and 50% of asset G

3 )50% of asset F and 50% of asset H

a. Calculate the expected return over the 4-year period for each of the three alternatives.

b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.

c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three alternatives.

d. On the basis of your findings, which of the three investment alternatives do you recommend? Why?

P8–23 Portfolio betas

Rose Berry is attempting to evaluate two possible portfolios, which consist of the same five assets held in different proportions. She is particularly interested in using beta to compare the risks of the portfolios, so she has gathered the data shown in the following table.

Portfolio weights

Asset Asset beta Portfolio A Portfolio B

1 1.30 10% 30%

2 0.70 30 10

3 1.25 10 20

4 1.10 10 20

5 0.90 40 20

Totals 100% 100%

a. Calculate the betas for portfolios A and B.

b. Compare the risks of these portfolios to the market as well as to each other. Which portfolio is more risky?

P9–1 Concept of cost of capital

Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.

Basic variables Project 263 Project 264

Cost $64,000 $58,000

Life 15 years 15 years

Expected return 8% 15%

Least-cost financing

Source Debt Equity

Cost (after-tax) 7% 16%

Decision

Action Invest Don’t invest

Reason 8% > 7% cost 15% < 16% cost

a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’ best interest.

b. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.

c. If the firm had used the weighted average cost calculated in part b, what actions would have been indicated relative to projects 263 and 264?

d. Compare and contrast the firm’s actions with your findings in part c. Which decision method seems more appropriate? Explain why.

P9–2 Cost of debt using both methods

Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a. Find the net proceeds from sale of the bond.

b. Show the cash flows from the firm’s point of view over the maturity of the bond.

c. Calculate the before-tax and after-tax costs of debt.

d. Use the approximation formula to estimate the before-tax and after-tax costs of debt.

e. Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?

P9–17 Calculation of individual costs and WACC

Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%. Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond. Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters. Common stock The firm’s common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2013) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table.

Year Dividend

2012 $3.75

2011 3.50

2010 3.30

2009 3.15

2008 2.85

It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings.((Assume that r1+=r5)

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the WACC for Dillon Labs.