Introduction to Managerial Finance

FINE 5200G, Winter 2015

Individual Assignment #2
Due on April 8 at the beginning of class
Important:

Your assignment can be either typed or hand-written. Make sure your handwriting is legible
if you submit a hand-written assignment.
You must explain your answers in detail and show all calculations. As for how much detail to
provide, the rule of thumb is that someone else must be able to replicate your numbers by
following your explanation. An example of what not to do is completing the problem entirely
in a spreadsheet and then simply cutting and pasting it into a word file without any
explanation. Although there is nothing wrong with using spreadsheets, you must fully explain
your calculations in words and/or formulas.
You must hand in a hardcopy of the assignment in person to the instructor on due date.
Softcopies (e.g., a PDF file by email) are not accepted except for (documented) medical or
other emergencies.
Penalty for late submission is a 20% reduction to the total possible marks for each day past
the deadline. Homework submitted one minute to 24 hours after the deadline (stated above)
is considered one day overdue. Late penalty may be waived if there are extenuating
circumstances (e.g., illness with documented proof) at the instructors discretion.

Question 1 (25%)
You currently own shares of Great Northern Timber Co. Analysts expect the companys earnings
and dividends to grow at a 3% annual rate indefinitely. Last year, the company paid a total amount
of dividends of $2.50 per share. Investors such as yourself require a rate of return of 10% for their
investment in the companys stock.
The company is evaluating several alternative business strategies going forward:
Continuing the present strategy which will result in the expected growth rate and required
rate of return shown above.
Expanding timber holdings and sales will increase the expected dividend growth rate to 6%
but will increase the risk of the company. As a result, the rate of return required by investors
will increase to 12%.
Integrating into retail stores will increase the expected dividend growth to 12% for the first
four years but drop to a lower growth rate of 5% afterwards due to anticipated competition.
Investors are expected to require a 14% return in this case.
a) (15%)
As a shareholder, which strategy is the best from your perspective? Why? Support your answer with
numbers and calculations.

b) (5%)
If the company were to implement the strategy of your best choice in a), what would be the
expected rate of return on your investment if you were to hold the stock over the next three years?
c) (5%)
Assume that the company decided to go with your best choice in a) as its new strategic plan. You
told a friend about the stock after the company just announced its new strategic plan. He decided to
buy some shares of the stock as well. What is his expected rate of return if he were to hold the stock
for the next three years?
Question 2 (20%)
Consider the investment in a portfolio of two stocks which have the following probability
distribution:
State
1
2
3
4

Prob.
0.15
0.30
0.40
0.15

Stock A (Ra)
0.00
0.05
0.10
0.20

Stock B (Rb)
0.40
0.20
0.05
-0.05

a) (15%)
Calculate the expected return and standard deviation for the following portfolios of the two
stocks:

Stock
A
B

I
0.00
1.00

II
0.25
0.75

Portfolio Weight
III
IV
0.50
0.75
0.50
0.25

V
1.00
0.00

b) (5%)
If you have to choose one of the five portfolios in part a), which one should it be and why?
Assume that the risk-free rate is 3%.
Question 3 (20%)
Each of two mutually exclusive projects involves an investment of $110,000. The estimated CFs
are as follows:
Project
Year
A
B
1
60,000
10,000
2
40,000
20,000
3
30,000
30,000
4
15,000
45,000
5
5,000
80,000
2

If the opportunity cost of capital is 12%, calculate the payback period, the NPV, the PI, and the
IRR for both projects. Which project should be chosen and why?
Question 4 (35%)
Mclean & Son Inc. (Mclean) is in the business of manufacturing frozen pizzas. It currently sells
most of its products to large grocery chains in Ontario. Exhibits 1 and 2 provide Mcleans
income statement and balance sheet for the most recent fiscal year. Mcleans corporate tax rate is
35% which is not expected to change in the future. Mclean believes that it has saturated the
Ontario market and its sales in Ontario are not expected to grow in the future.
The company is now evaluating a proposal to sell frozen pizzas in Quebec and other provinces
on the east coast. Several grocery chains operating in these provinces have expressed interest in
signing long-term contract with Mclean to supply frozen pizzas to their stores. Mclean currently
sells 36 million frozen pizzas a year, all in Ontario. By expanding in Quebec and the eastern
provinces, Mclean expects that the additional business would add 7.2 million units next year, an
additional 6 million units the following year, a further 4.2 million units the year after, reaching a
total of 17.4 million additional units in three years. Beyond that, no further gains in sales are
expected.
To add an additional 17.4 million unit capacity, Mclean needs to undergo a major expansion to
its current manufacturing facility at a total upfront cost of $16.5 million. The new equipment is
expected to have a 10-year life with no salvage value at the end. The expansion also requires
additional working capital of $750,000 upfront. Subsequently, the net work capital each year will
be the sum of inventory and accounts receivables less accounts payable, all of which are
proportional to sales. The new equipment also provides CCA deductions for the next ten years,
as summarized in Exhibit 3.
There are also some economies of scale associated with the expansion, leading to a firm-wide
reduction in production cost of $0.021 per unit. There are also savings in other operating
expenses of $140,000 a year. Both figures are estimated at todays prices and expected to
increase at the rate of inflation each year.
Currently Mclean sells its frozen pizzas to its customers for $2.80 per unit and prices are
expected to increase at the pace of inflation which is expected to be 2% for the foreseeable
future. Production costs are expected to increase at the same rate.
a) (25%)
Mclean evaluates all new capital budgeting projects with a hurdle rate of 15%. In that case,
should Mclean proceed with the expansion?
b) (5%)
The hurdle rate used in a) above does not necessarily reflect the actual cost of capital for Mclean.
As the proposed expansion does not lead to any fundamental change to Mcleans business
activities, it is reasonable to argue that the expansion does not alter its overall risk level. Use the
3

information below to estimate Mcleans current cost of capital:

The target capital structure is 40% debt and 60% equity.

Mcleans common stock has a beta of 1.2 and the market risk premium is 5%.
Mcleans long-term bonds current yields 7.06%. Canadian government bonds with
comparable terms yield 2.06%.

c) (5%)
Use the cost of capital estimated in b) to reevaluate the proposed expansion. How does this
analysis change your recommendation for the expansion project?

Exhibit 1
Income Statement ($million)
Sales
Costs of goods sold
Operating expenses
EBIT
Interest
Taxable income
Taxes
Net income

$ 100.8
35.3
55.4
$ 10.1
1.6
8.5
3.0
$ 5.5

Exhibit 2
Balance Sheet ($million)

Assets
Cash
Accounts receivables
Inventory
Prepaid expenses
Other current
Total current assets
Fixed assets
Total assets

$
$

13.1
12.1
7.1
2.2
0.9
35.4
36.4
71.8

Liabilities and
Stockholders Equity
Accounts payable
$
Other current
Total current liabilities $
Long-term debt
Shareholders equity

8.1
2.2
10.3
24.2
37.3

Total liabilities & equity

71.8

Exhibit 3
Eligible CCA Deduction
Year
1
2
3
4
5
6
7
8
9
10

Deduction
$ 1,377,000
$ 2,436,000
$ 1,881,000
$ 1,464,000
$ 1,146,000
$
909,000
$
726,000
$
588,000
$
483,000
$ 5,493,000