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##### After having taken the fascinating FRL367 class yo...

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After having taken the fascinating FRL367 class you decided that you want to start your own business and apply your finance knowledge to make big bucks. And so several years ago you and a couple 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 even started issuing its own stock a year ago. It currently has 10,000 shares outstanding, owned by the co-owners 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 decided it?s a good time to evaluate your company?s riskiness and compare it with the risk of the competitors. 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 your company?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. The assistants did some research and concluded that the risk of ?Poly Tunes? reflects the average risk of the competitors. The assistants also applied their statistical knowledge to analyze past data on various financial investments, including the competitors? stocks. Their study produced the following summary of the annual returns for each investment for the last 7 years: Year Annual returns (%) I-Music You-Tunes Songs ?R US S&P 500 stock index U.S. Treasury bills 2008 45 -5 51 38 3 2007 -5 0 20 22 3 2006 -10 15 1 5 3 2005 -10 18 -16 -13 3 2004 22 -9 30 -3 3 2003 8 0 0 18 4 2002 37 15 -15 -37 4 However, due to music industry instability prior to 2005, including data on annual returns for years 2002 through 2004 would create a negative bias in the risk valuation of these investments. And so the research assistants decided to only include data for the most recent four years into their statistical analysis. Based on the last four years? observed returns, they concluded that in the next years each of the 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 evaluating a new investment project: opening a new ?Poly Tunes? location in Pasadena. They were asked to analyze the projected revenues and costs and advise your company on whether the project would be profitable. Below is the information regarding the project: How long the new store will stay running for 5 years Initial investment into equipment, etc. raised solely from new equity issues $300,000 Number of music CDs sold in year 1 (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 be getting a 10% discount on their entire purchases.) 22,000 Average price a regular customer pays for a CD $10 Cost of making a CD copy, cover, labels, and other variable costs per CD $4 Cost of making a sample single-song CD with a song of the most recent American Idol show winner offered for free to customers per each CD sold $0.5 Maintenance expenses, alarm system, fire insurance, and other fixed costs that need to be paid annually $30,000 Beta of the project 0.9 Corporate tax rate is 34%. The physical equipment purchased for the store will fully depreciate on the 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 store competitors. Which one of the five has the highest total risk (explain what total risk means)? The highest 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 on past data, and they concluded that the company?s stock correctly reflects its systematic risk. Based on 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 investment project? 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?s managers to accept or reject the new Pasadena project? Calculate the net present value of the proposed project. Calculate and explain all calculations. Question 5. (4 points) How would the systematic risk of the company change if the project got accepted? For that you can use the information given earlier about the company?s current capital structure, and the fact that another $300,000 worth of additional equity was raised to cover the initial cost of the project. (Hint: you can view the new company with the project as a portfolio.) Calculate the answer and explain your calculations. Question 6. Together with your co-owners, you did some additional calculations and came to conclusion that paying for the initial investment of the project with equity alone is not optimal. You believe that financing seventy percent of total initial investment by debt and the remaining amount by equity would be a good target debt-equity ratio, and that using it would maximize the value of the Pasadena music store project. There is a slight chance that the debt obligations may not be covered in full if the annual revenues are lower than originally estimated. For this reason, creditors require a 2 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 the principal 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. (b) (4 points) What is the current value of the project using the Cash Flow-to-Equity (FTE) approach? Calculate and explain. (c) (4 points) Finally, what would be the current value of the project based on the Weighted Average Cost of Capital (WACC) approach? Calculate and explain. EXTRA CREDIT (5 points) Question 7. Would your answers to Question 6-(a), (b), (c) change if the debt instead looked like a five-year amortizing loan, with fixed total annual payments in all five years? (You can review what amortizing loans look like in Ross, Westerfield, Jordan textbook that you used in FRL300 class, or you can use other sources.) Explain all calculations as well as what changes in your answers to 6-(a), (b), and (c), where necessary.

Paper#5665 | Written in 18-Jul-2015

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