Question

1. Litten Oil and Gas Company is a large company with common stock listed on the New York Stock Exchange and bonds traded over the counter.

The vice president of finance is planning to sell $75 million of bonds this year. Present market yields are 12.1%. Litten has $90 million of 7.5% non callable preferred stock outstanding and has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at $80 per share and its dividend per share is $7.80.

The company has had volatile earnings but its dividend per share had had 8% growth and this will continue. The expected dividend is $1.90 per share and common stock is selling for $40 per share. The company’s flotation costs are $2.50 per share preferred stock and $2.20 per share for common stock.

Litten keeps its debt at 50% of assets and its equity at 50%. Litten sees no need to sell common or preferred stock in the near future as is has generated enough internal funds for investment needs. The tax rate for the company is 40%

Calculated the following cost of capital:

a. bond

b. preferred stock

c. common stock in retained earnings

d. new common stock

e. weighted average cost of capital.

2. Smith Corporation is considering two new investments. Project A and Project B are listed below

Project A will cost $20,000 and has the following cash flow

Yr 1 5,000

Yr 2 6,000

Yr 3 7,000

Yr 4 10,000

Project B will also cost $20,000 has the following cash flow

Yr 1 16000

Yr 2    5000

Yr 3    4000

Calculate specific payback for each

Calculate NPV of each. Use the weighted cost of capital of 8%

Answer 1

2. CALCULATE SPECIFIC PAYBACK OF PROJECT A

YEAR CASHFLOW CUMULATIVE CASHFLOW

0 ($20000) ($20000)

1 $5000 ($15000)

2 $6000 ($9000)

3 $7000 ($2000)

4 $10000 $8000

PAYBACK PERIOD OF PROJECT A

= 3 + ( - $2000 / $10000 )

= 3 + ( $2000 / $10000 )

= 3 + 0.2

= 3.2 years

PAYBACK OF PROJECT B

0 ($20000) ($20000)

1 $16000 ($4000)

2 $5000 $1000

3 $4000 $5000

PAYBACK PERIOD OF PROJECT B

= 1 + (- $ 4000 / $ 5000 )

= 1 + ( $4000 / $5000 )

= 1 + 0.8

= 1.8 years

CALCULATE NPV OF PROJECT A

NPV ( A ) = ( - $20000 ) + $5000 / (1.08)1 + $6000 / (1.08)2 + $7000 / (1.08)3 + $10000 / (1.08)4

= ( - $20000 ) + $4629.63 + $5144.03 + $5556.83 + $7350.30

= $2680.80

NPV ( B ) = ( - $20000 ) + $ 16000 / (1.08)1 + $5000 / (1.08)2 + $4000 / (1.08)3

= ( - $20000 ) + $14814.81 + $4286.70 + $ 3175.33

= $ 2276.84