Question

1) The Patches Group has invested $26,000 in a high-tech project lasting three years. Depreciation is $8,100, $11,300, and $6,600 in Years 1, 2, and 3, respectively. The project generates pretax income of $3,530 each year. The pretax income already includes the depreciation expense. The tax rate is 34 percent.

What is the project’s average accounting return (AAR)? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

AAR ____ %

2) Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next nine years, because the firm needs to plow back its earnings to fuel growth. The company will pay a dividend of $12 per share exactly 10 years from today and will increase the dividend by 6 percent per year thereafter. If the required return on this stock is 11 percent, what is the current share price? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Current share price           $

Answer 1

1.Average Accounting Return = Average income after tax/Average Investment

Average Income after Tax = 3,530*(1-34%) = $2,329.8

Calculation of Average Investment:

Year	Initial Investment	Depreciation Charge	Closing Investment	Average Investment
1	26,000	8,100	17,900	21,950
2	21,950	11,300	10,650	16,300
3	16,300	6,600	9,700	13,000

Average Investment over the 3 years = (21,950+16,300+13,000)/3 = 17,083.33

Accounting Rate of Return = 2,329.8/17,083.33

= 13.64%

2.Price of share is equal to the present value of future dividends

Price of Stock after 9 years = Dividend Year 10/(Required Rate – Growth Rate)

= 12/(11%-6%)

= $240

Current Share Price = 240/(1.11)⁹

= $93.82