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FRL 367 Homework Assignment 3




Question;?Music Store Project?? Total points: 30? Due February 21 (Tue.) at the beginning of the lecture.? You can work on this homework alone or with one other student in class. If you work withone other student, please turn in just one set of solutions with both names on it ? both willreceive the same grade.? Half of the score for each problem is based on your write-up, i.e., an explanation of what youare calculating in each step and why ? for full credit show all calculations (i.e., formulasused, numbers that go into the formulas, or what you plug into your financial calculator) andbriefly explain in words why you are doing what you are doing with each step of yourcalculations.? To turn in your homework solutions:o Type your solutions in Word (.doc file).o Email to me this Word document file by the beginning of February 21 lecture. Thesolutions will not be graded until I?ve received the electronic version. If you work withone other student, please indicate both partners? names in the email.FORMATS OTHER THAN ?WORD? DOCUMENT ? such as Excel spreadsheets orprintscreens thereof ? WILL NOT BE ACCEPTED. (I will not be clicking on the cells ofyour spreadsheets to check where the numbers came from.)If you did part of your work in Excel you can create a table in your Word document &add a write-up which clearly explains where all new numbers in your table come from(see 4th bullet point above).o Print out the same Word document file with your solutions and turn this hard copy in tome by the beginning of February 21 lecture. The hard copy should be identical to theemailed solutions.o You can definitely turn in your homework solutions earlier, if you want.?Feel free to email to me your questions on the homework or ask those during office hours?After having taken the fascinating FRL367 class you decided that you want to start your ownbusiness and apply your finance knowledge to make big bucks. And so several years ago you and acouple of your friends from Cal Poly opened a music store in the area, and you called your store?Poly Tunes?.The company grew large and opened additional music store locations very quickly, and it evenstarted issuing its own stock a year ago. It currently has 10,000 shares outstanding, owned by the coowners of the store. Each share of stock is priced at $90.In recent years the competition with other music stores has been getting higher, and so you decidedit?s a good time to evaluate your company?s riskiness and compare it with the risk of thecompetitors. You decided to hire a group of Research Assistants to do an analysis of the companies?performances over the last several years and try to make a prediction regarding their, as well as yourcompany?s, performances in the future.The Research Assistants identified three main competitors in the music store business: I-Music,You-Tunes, and Songs ?R Us. These three companies have roughly the same market value. Theassistants did some research and concluded that the risk of ?Poly Tunes? reflects the average risk ofthe competitors. The assistants also applied their statistical knowledge to analyze past data onvarious financial investments, including the competitors? stocks. Their study produced the followingsummary of the annual returns for each investment for the last 7 years:Annual returns (%)Songs ?R USS&P 500 stockindex51382022YearI-MusicYou-Tunes200820072006200520042003200245-5-50-1015153-1018-16-13322-930-338001843715-15-374U.S. Treasurybills33However, due to music industry instability prior to 2005, including data on annual returns for years2002 through 2004 would create a negative bias in the risk valuation of these investments. And sothe research assistants decided to only include data for the most recent four years into their statisticalanalysis. Based on the last four years? observed returns, they concluded that in the next years each ofthe four observed returns may occur again and the four possibilities are equally likely.Your successful company hired one more team of researchers who would be in charge of evaluatinga new investment project: opening a new ?Poly Tunes? location in Pasadena. They were asked toanalyze the projected revenues and costs and advise your company on whether the project would beprofitable. Below is the information regarding the project:How long the new store will stay running forInitial investment into equipment, etc. raised solely from new equity issuesNumber of music CDs sold in year 125 years$300,00022,000(This number is estimated to increase by 1,000 in each of the following years.In each year, 40% of all buyers are expected to be college students, and they will begetting a 10% discount on their entire purchases.)Average price a regular customer pays for a CDCost of making a CD copy, cover, labels, and other variable costs per CDCost of making a sample single-song CD with a song of the most recent AmericanIdol show winner offered for free to customers per each CD soldMaintenance expenses, alarm system, fire insurance, and other fixed costs that needto be paid annuallyBeta of the project$10$4$0.5$30,0000.9Corporate tax rate is 34%. The physical equipment purchased for the store will fully depreciate onthe straight line over the full project life at the end of which it will be given away to thrift stores.Based on the above information, answer the following questions:Question 1. (4 points) Calculate the Betas of T-bills, S&P500 and the three music storecompetitors. Which one of the five has the highest total risk (explain what total risk means)? Thehighest systematic risk (explain what systematic risk means)? Calculate and explain all calculations.Question 2. (3 points) The first team of researchers analyzed ?Poly Tunes?? performance based onpast data, and they concluded that the company?s stock correctly reflects its systematic risk. Basedon this, what is the annual rate of return on equity that investors require? Calculate and explain.Question 3. (3 points) What is the weighted average cost of capital for the proposed investmentproject? Is the project as risky as the company? Calculate and explain.Question 4. (4 points) Would the second team of researchers recommend ?Poly Tunes? company?smanagers to accept or reject the new Pasadena project? Calculate the net present value of theproposed project. Calculate and explain all calculations.Question 5. (4 points) How would the systematic risk of the company change if the project gotaccepted? For that you can use the information given earlier about the company?s current capitalstructure, and the fact that another $300,000 worth of additional equity was raised to cover the initialcost of the project. (Hint: you can view the new company with the project as a portfolio.) Calculatethe answer and explain your calculations.Question 6. Together with your co-owners, you did some additional calculations and came toconclusion that paying for the initial investment of the project with equity alone is not optimal. Youbelieve that financing seventy percent of total initial investment by debt and the remaining amountby equity would be a good target debt-equity ratio, and that using it would maximize the value of thePasadena music store project. There is a slight chance that the debt obligations may not be coveredin full if the annual revenues are lower than originally estimated. For this reason, creditors require a2 percent higher expected return compared to that on the U.S. Treasury bills. It is interest-only loan,which means that the company will be required to make interest payments for five years, and theprincipal will be fully repaid at the end of the fifth year.(a) (4 points) What is the current value of the project using the Adjusted Present Value(APV) approach? Calculate and explain.3(b) (4 points) What is the current value of the project using the Cash Flow-to-Equity (FTE)approach? Calculate and explain.(4 points) Finally, what would be the current value of the project based on the WeightedAverage Cost of Capital (WACC) approach? Calculate and explain.(c)EXTRA CREDIT (5 points)Question 7. Would your answers to Question 6-(a), (b), (c) change if the debt instead looked like afive-year amortizing loan, with fixed total annual payments in all five years? (You can review whatamortizing loans look like in Ross, Westerfield, Jordan textbook that you used in FRL300 class, oryou can use other sources.) Explain all calculations as well as what changes in your answers to 6-(a),(b), and (c), where necessary.


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