book PS5_solutions starts at ch17

# book PS5_solutions starts at ch17 - Rose-Hulman Institute...

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Rose-Hulman Institute of Technology / Department of Humanities & Social Sciences / K. Christ Fall Quarter, 2009 – 2010 / SL 351, Managerial Economics; EMGT 531, Economics for Technical Managers Problem Set 5 -- Solutions P17.3 A. Increase. A general rise in interest rates will increase the cost of debt, and increase the weighted average cost of capital used in investment project evaluation. B. Increase. As stock prices fall, the required return per dollar of equity capital will rise. This will force upward the weighted average cost of capital used in investment project evaluation. C. Decrease. As state corporate income taxes fall, the after-tax component cost of debt will rise and increase the relative attractiveness of equity financing. The firm’s weighted average cost of capital will decline, however, as the after-tax returns available to debt plus equity holders will increase from a given stream of cash flows, and cause bond and stock prices to rise. D. Increase. As federal corporate income tax rates rise, the after-tax returns available to debt plus equity holders will fall, and the weighted average cost of capital will increase. On a relative basis, debt will become preferred to equity financing. E. Decrease. Holding all else equal, an increase in the stock price for a company will reduce the component cost of equity and the weighted average cost of capital.

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P17.6 A. Permian Basin #1 E(CF 1 ) = \$1,000,000 σ 1 = \$200,000 CV 1 = 0.2 Permian Basin #2 E(CF 2 ) = \$900,000 σ 2 = \$360,000 CV 2 = 0.4 Notice that CV2 = 2*CV1 (Factor of 2 will be used to calculate RADR for Project #2.) B. Permian Basin #1 NPV 1 = (PVIFA, N = 10, i = 8% + 12% = 20%) × E(CF 1 ) - Cost = (4.1925)(\$1,000,000) - \$3,000,000 = \$1,192,500 Permian Basin #2 NPV 2 = (PVIFA, N = 10, i = 8% + 2(12%) = 32%) × E(CF 2 ) - Cost = (2.9304)(\$900,000) - \$3,000,000 = -\$362,640 (A loss) Therefore, the less risky Permian Basin #1 has a positive NPV 1 and should be undertaken, whereas the more risky Permian Basin #2 project has an NPV 2 < 0 and should be rejected. ( Note : V 2 = 2V 1 so the appropriate risk premium for Permian Basin #2 is 24% = 2 × 12%.) C. Permian Basin #1 : PI 1 = 4,192,500 / 3,000,000 = 1.398 Permian Basin #2 PI 2 = 2,637,360 / 3,000,000 = 0.879 Because the PI 1 > PI 2 , the Permian Basin #1 project is ranked ahead of the Permian Basin #2 project. Moreover, because PI 2 < 1, this latter project should not be pursued in any event.
P17.7 A. Project A Year 1 : E(CF A1 ) = \$50,000 σ A1 = \$30,000 CV A1 = 0.6 Year 2 : E(CF A2 ) = \$50,000 σ A2 = \$20,000 CV A2 = 0.4 Project B Year 1 : E(CF B1 ) = \$100,000 σ B1 = \$100,000 CV B1 = 1 Year 2 : E(CF B2 ) = \$100,000 σ B2 = \$50,000 CV B2 = 0.5 B. Project B has a higher standard deviation and coefficient of variation in project returns and, therefore, is the more risky of the two investment projects.

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book PS5_solutions starts at ch17 - Rose-Hulman Institute...

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