Question

a) A beauty product company is developing a new fragrance. There is 50% probability that consumers will love the new product, in this case the annual sales will be 1 million bottles. There is a 40% probability the consumers will find the smell acceptable and annual sales will be 200,000 bottles. With10% probability consumers will find the smell unusual and annual sales will be only 50,000 bottles. The selling price is £38 and the variable cost is £8 per bottle. Fixed production costs are £1 million per year and depreciation is £1.2 million per year. Assume that the tax rate is 40%. What are the expected annual incremental cash flows for the new fragrance? [10 marks]

b) Information Systems Ltd is planning to issue 10-year bonds with £1,000 face value. The market rate for such bonds (yield) is 8.125%. Assume that coupon payments will be semi-annual. The firm is deciding between issuing an 8% coupon bond or a zero- coupon bond. The company needs to raise £1 million.

i) What will be the price of the 8% coupon bonds? How many coupon bonds would have to be issued? [7 marks]

ii) What will be the price of the zero-coupon bonds? How many zero-coupon bonds will have to be issued? [7 marks]

c) You know that the return of ordinary shares of ABC company reacts to macroeconomic information 1.6 times more than the return of the market. If the risk-free rate of return is 4% and the market risk premium is 6%, what is ABC’s cost of equity? [6 mark]

Answer 1