ACTSC 372 – Assignment 4 – due on March 30, 2007
1.
[3 points] You own 100 shares of Remko Inc., which will pay a dividend of $2.50 per share at the end
of each year for the next two years. Three years from now, Remko Inc. will close and the liquidating
value returned to the shareholders will be $16.5 per share. The required return on Remko’s stock is
13%. (a) What is the current price of Remko’s stock? (b) If you prefer to receive an equal amount of
money every year in each of the next three years, how can you accomplish this (only using transactions
on Remko’s stock)?
Solution:
(a) The current price
P
0
is equal to the present value of the future cash flows, and is thus
given by
P
0
=
2
.
50
1
.
13
+
2
.
50
1
.
13
2
+
16
.
50
1
.
13
3
= 15
.
61
(b) The level amount that can be obtained from the 100 shares is the value
x
such that
100
P
0
=
xa
3 13%
,
where
a
3 13%
= (1

1
.
13

3
)
/
0
.
13 = 2
.
3611. Solving for
x
, we find
x
= 660
.
93. To get this amount,
we’ll need to sell some shares at time 1 and 2. To determine how much shares we need to sell, we need
to figure out (1) the value of the stock at those times (2) how much dividends we get, which in turn
depends on how many shares we have. Now, at time 1 (after the dividend is paid), the value of the
stock becomes
P
1
=
2
.
50
1
.
13
+
16
.
5
1
.
13
2
= 15
.
13
.
We get 100
×
2
.
50 = 250 in dividends, and thus we need to sell enough shares to make up for the
difference 660.93  250 = 410.93, which means we need to sell 410.93/15.13 = 27.15
≈
27 shares. So at
time 2, now the stock price is 16.50/1.13 = 14.60, and we get (100

27)
×
2
.
50 = 182
.
5 in dividends,
so we need to sell
660
.
93

182
.
50
14
.
60
= 32
.
77
≈
33 shares
.
Hence at time 3, we’re now left with 1002733 = 40 shares, and thus get a total of 40
×
16
.
50 = 660
at time 3 (not exactly 660.93 because of roundoff errors).
2.
[3 points] Jensen Inc. currently has a debttoequity ratio of 30%, and the required return on the
firm’s levered equity is 17%. The applicable corporate tax rate is 35%. Jensen Inc. is considering a
project that requires an initial investment of 14 million, and that will generate aftertax cash flows of
3, 7 and 8 millions at the end of year 1, 2, and 3, respectively. Jensen is planning to issue 4.5 million in
debt to partially finance the project. The company’s borrowing rate is 9%. The loan contract specifies
that at the end of each year, Jensen will pay 9% on the outstanding balance at the beginning of the
year, and that it will make yearend principal payments of 1.5 million per year. Using the APV method,
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 Winter '09
 MARYHARDY
 Utility, APV, debttoequity ratio, respective probabilities

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