FNCE100_PS4 - University of Pennsylvania The Wharton School...

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Unformatted text preview: University of Pennsylvania The Wharton School FNCE 100 A. Craig MacKinlay PROBLEM SET #4 Fall Term 2005 Capital Budgeting (Uncertainty) 1. Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas producer, are thinking of investing in a natural gas well near Pittsburgh. The well that Dow is thinking of investing in is located north of Pittsburgh, while Superior Oils would be south of Pittsburgh, but otherwise the projects are identical. Both companies have analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. Both companies estimate that their project would have a net present value of $1.0 million at an 18 percent nominal discount rate and a -$1.1 million NPV at a 22 percent discount rate. Dow has an asset beta of 1.25 and Superior Oil has an asset beta of 0.75 which is equal to the beta of natural gas production. The expected risk premium on the market is 8.0 percent and risk-free bonds are yielding 12.0 percent. Should either company proceed? Both? Why? 2. Beatrice Foods is a large conglomerate that manufactures Dannon Yogurt, Melnor Lawn Sprinklers, and Samsonite Luggage, among other items. CBS is a broadcasting and movie company whose size and debt-equity ratios are similar to those of Beatrice Foods. Beatrice and CBS both have stock betas of approximately 1.0. One would expect that the fraction of the total variability of each companys stock returns that is due to unique risk is: (a) Higher for CBS than for Beatrice (b) Lower for CBS than for Beatrice (c) Probably similar because size and debt-equity ratios are similar....
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FNCE100_PS4 - University of Pennsylvania The Wharton School...

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