FIN 301 Midterm 2 Review Questions

Java Python FIN 301

Midterm 2, Review Questions

1. Ronstadt Inc.

a) Ronstadt Inc. generates $4 per share in earnings. It has 2,000,000 shares outstanding. Ronstadt is in a steady state and pays out all of its earnings as dividends. This situation is expected to last into the foreseeable future. How much would you pay for a share of Ronstadt Inc. if the required rate of return is 12%?

b) Suppose Ronstadt has a new project come available. If Ronstadt invests, it will need to pay $8 million next year (t = 1). The project will provide $5 million cash flow in each of the following three years (C = $5 million, t = 2, 3, and 4). What is the price of a share of Ronstadt?

c) What if you found out that while Ronstadt’s new project will indeed cost $8 million the future cash flows will only be half of the previous estimate (C = $2.5 million, t = 2, 3, and 4)? You also learn that management will implement the new project despite the new lower cash flow estimate. Compare the original P/E ratio (e.g. from the “old” Ronstadt in part a) to the P/E ratio of each of the “new” Ronstadts in parts b) and c). How do growth opportunities affect P/E ratios?

2. Second Hand Ideas Inc. (SHI) is a maker of various low-tech small domestic appliances. SHI is considering a new product called the SmartFone, a personal digital assistant. The SmartFone project requires an initial investment of $400 million today (the necessary equipment has a CCA rate of 30%, the AII applies, and a 40 million salvage value in four years). The following table is a forecast of project related revenues and expenses in millions of $ (excluding CCA):

	Year 1	Year 2	Year 3	Year 4
Sales	160	220	280	180
Expenses (Excluding CCA)	90	80	120	80

The project requires an immediate $10 million increase in Net Working Capital (NWC) at t=0. In subsequent years, NWC will be 10% of total sales. SHI’s required rate of return is 10%, and the corporate tax rate is 40%