1. Dalton Enterprises is experiencing financial difficulty due to environmental concerns about the safety of the firm’s fission-powered cars. Further, given the recent decline in the cost of the fossil fuels that power conventional automobiles, there is now a 10 percent probability that Dalton will default on its outstanding zero coupon bonds that mature in exactly two years. In the event of a default, bondholders can expect to recover 40 percent of the bond’s par value of $1000. The risk-free rate of interest is 3.0 percent. Assuming that all interest rates are compounded annually, and that investors value risky bonds by discounting the expected payoff at the risk-free interest rate, determine the promised yield to maturity for Dalton’s outstanding zero coupon bonds having two years to maturity
2. Justin Thomas has just retired at age 64. Thomas plans to fund his retirement income using a Roth IRA (non-taxable retirement account), which currently has a value of $2,500,000. Thomas expects to live for 27 more years. During retirement, he plans to withdraw income from his retirement account once every 18 months, with the first withdrawal to occur immediately and the last withdrawal occurring 18 months prior to his death (at age 91). Thomas is confident that his retirement account will earn a semiannually compounded return of 9 percent per year. Prices are expected to increase at a semiannually compounded rate of 4.2 percent per year due to inflation. Assuming Thomas wants the purchasing power of his periodic withdrawals/income to remain constant during retirement, determine the maximum initial withdrawal that can be made from the retirement fund assuming there is one withdrawal every 18 months, with the first withdrawal to occur immediately, and that no withdrawal occurs at the end of the 27-year retirement period.
3. The Board of Directors for Cypress Corp is considering a proposal by the CEO to sell the firm’s disk drive division. An anonymous buyer has offered through a business broker to purchase the disk drive division from Mountain View for $600 million. Since the book value of the disk drive division is also $600 million, there would be no taxes on the sale. Disk drive sales in the upcoming fiscal year are expected to be $1,000 million ($1 billion). However, yearly sales have been declining steadily at a rate of 5 percent per year. The CFO believes that this sales trend cannot be reversed, and that sales will continue to decline in perpetuity at a rate of 5 percent per year due to relentless competition from foreign manufacturers located in Uruguay. As further evidence supporting the proposed sale, the CEO notes that the firm’s profit margin on disk drive sales is only 12 percent (of sales). The CFO has argued that selling the disk drive division is not attractive because the proposed sale has an internal rate of return that is less the firm’s opportunity cost of capital of 10 percent. Assuming that Cypress has a marginal tax rate of 40 percent,
a. determine the internal rate of return for the proposed sale of the division,
b. explain whether Board should approve the sale of the disk drive division.
4. Colorado Mining Co. is planning to purchase of a new hydraulic mining shovel to mine copper ore in the Arizona desert. A new Joy 4800 XPC from Komatsu, with a 4500 horsepower engine and a 65 cubic meter bucket capacity, has a cost of $40 million and an economic life of 10 years. The Joy 4800 XPC would use $2.1 million of diesel fuel each year and would have operating costs of $40 million per year. The firm is also considering the purchase of a Caterpillar 6060 FS, with a 3200 horsepower engine and bucket capacity of 34 cubic meters. The Caterpillar 6060 FS has a cost of $30 million and an economic life of 8 years. Although the Caterpillar 6060 FS is less expensive and would use only $1.8 million of diesel fuel per year, the 6060 would have the same yearly production as the Joy 4800. However, the yearly costs of operating the Caterpillar 6060 would be $44 million. Both shovels would have zero salvage values at the end of their respective economic lives. The Internal Revenue Service permits mining equipment to be depreciated to a zero salvage value using straight-line depreciation over a 5-year life. Assuming that Colorado Mining Co. has a tax rate of 35 percent and a required return of 11 percent, determine whether the firm should purchase the Joy 4800 XPC or the Caterpillar 6060 FS.
5. You just purchased a risk-free US Treasury note having 3 years to maturity and an annual coupon rate of 6.5 percent. Assume that the coupon/interest payments for Treasury notes are made once per year (coupon payments occur annually). The annualized yield to maturity for a risk-free zero coupon bond that matures in one year is 1.75 percent. The annualized forward interest rate for a 1-year period that begins in 1 year is 2.50 percent, while the forward rate of interest for a 1-year period that begins in 2 years is 3.00 percent,
a. determine the annualized yield to maturity for risk-free zero coupon bond that mature respectively in 2 years and in 3 years
b. determine the annual coupon rate for a U.S. Treasury note having a market price of $1041.35 having two years to maturity and a par value of $1000.
c. determine the current market price for a Treasury note having 3 years to maturity and an annual coupon rate (and payment) of 6.5 percent.
d. determine the annualized yield to maturity for the 6.5 percent (coupon) Treasury note having 3 years to maturity
6. The CFO for Pittsburgh Steel is evaluating a proposal to build the world’s first “green” aluminum mini-mill. The mini-mill, which will require an initial investment of $1.4 billion, will have an economic life of 10 years but can be depreciated to a zero salvage value over a 7-year depreciable life. The mini-mill is expected to create 800 jobs and have the capacity to produce 600,000 tons of flat-rolled aluminum each year for the automobile and defense industries. Flat-rolled aluminum is expected to sell for $2100 per ton over the next year. The production of each ton of aluminum will require raw materials (alumina, bauxite and carbon) having a cost of $800. The wages, pension and health-care benefits for each job in the mill will cost $120,000 over the next year. The production of each ton of aluminum strength aluminum will require 12,500 kilowatt hours of electricity. The cost of electricity will be $0.05 per kilowatt hour next year, but is expected to increase by 4 percent per year over the next 10 years. Although the cost of raw materials and the selling price of aluminum are expected to remain constant over the next 10 years, labor costs are expected to increase at 2 percent per year. At the end of 10 years, the minimill is expected to have an after-tax salvage value of $50 million. Assuming that PS has a marginal tax rate of 40 percent and a required return of 12 percent, determine the Net Present Value of the proposed investment.