Market Investment

PART 1

1. Avalon Building is a prospective buyer of an apartment building on leased land. At the end of 20 years, the land and the building revert to the lessor with no terminal value to the buyer. Annual rentals on the building are expected to be $126,000, while maintenance and other cash expenses are expected to average $60,000 per year.
   • If Van Auken’s opportunity cost of funds is 13 percent, what is the maximum price she should pay for the building?
2. Bienvenue Inc., is considering investing in Japan. It makes a bid to the government to participate in the development of a mine, the profits of which will be realized at the end of 5 years. The mine is expected to produce $5 million in cash to Barquez at that time. Other than the bid at the outset, no other cash flows will occur, as the government will reimburse the company for all costs. If Barquez requires a return of 20 percent, what is the maximum bid it should make for the participation right if interest is compounded:
   • Annually
   • Semiannually
3. Gartner Group has an 8 percent preferred stock issue outstanding, with each share having a $100 face value. Currently, the yield is 10 percent.
   • What is the market price per share?
   • If interest rates in general should rise so that the required return becomes 12 percent, what will be the market price per share?
4. Compu-Serve currently pays a dividend of $2 per share, and this dividend is expected to grow at a 15 percent annual rate for 3 years, then at a 10 percent rate for the next 3 years, after which time it is expected to grow at a 5 percent rate forever.
   • What value would you place on the stock if an 18 percent rate of return were required?
5. Assuming that the capital-asset pricing model approach is appropriate:
   1. Compute the required rate of return for each of the following stocks, given a risk-free rate of 0.07 and an expected return for the market portfolio of 0.13.

6. You have agreed to pay a creditor $5,000 one year hence, $4,000 two years hence, $­3,000 three years hence, $2,000 four years hence, and a final payment of $1,000 five years from now. Because of budget considerations, you would like to make five equal annual end-of-period pay­ments to satisfy your contract. 

• If the agreed-upon interest rate is 5 percent per year, what will the annual payments be?

7. Walmart must replace a number of its concrete mixer trucks with new trucks. It has received
several bids and has evaluated closely the performance characteristics of the various trucks.

• The Patterbilt truck, which costs $74,000, is top-of-the-line equipment. The truck has a life of 8 years, assuming that the engine is rebuilt in the fifth year. Maintenance costs of $2,000 a year are expected in the first 4 years, followed by total maintenance and rebuilding costs of $13,000 in the fifth year. During the last 3 years, maintenance costs are expected to be $4,000 a year. At the end of 8 years the truck will have an estimated scrap value of $9,000.
• A bid from Bulldog Trucks, Inc., is for $59,000 a truck. Maintenance costs for this truck will be higher. In the first year they are expected to be $3,000, and this amount is expected to increase by $1,500 a year through the eighth year. In year 4 the engine will need to be rebuilt, and this will cost the company $15,000 in addition to the maintenance costs in that year. At the end of 8 years the Bulldog truck will have an estimated scrap value of $5,000.
• The last bidder, Best Tractor and Trailer Company, has agreed to sell trucks at $44,000 each. Maintenance costs in the first 4 years are expected to be $4,000 the first year and to increase by $1,000 a year.  For the city’s purposes, the truck has a life of only 4 years. At that time it can be traded in for a new Best Truck, which is expected to cost $52,000. The likely trade-in value of the old truck is $15,000. During years 5 through 8 the second truck is expected to have maintenance costs of $5,000 in year 5, and these are expected to increase by $1,000 each year. At the end of 8 years the second truck is expected to have a resale or salvage value of $18,000.

SHOW YOUR WORK!

• If the City of San Jose’s opportunity cost of funds is 8 percent, which bid should it accept? Ignore tax considerations, as the city pays no taxes.
  • If its opportunity costs were 15 percent, would your answer change?

SAMPLE ANSWER:

·         The Patterbilt truck, which costs $74,000, is top-of-the-line equipment. The truck has a life of 8 years, assuming that the engine is rebuilt in the fifth year. Maintenance costs of $2,000 a year are expected in the first 4 years, followed by total maintenance and rebuilding costs of $13,000 in the fifth year. During the last 3 years, maintenance costs are expected to be $4,000 a year. At the end of 8 years the truck will have an estimated scrap value of $9,000.
·         A bid from Bulldog Trucks, Inc., is for $59,000 a truck. Maintenance costs for this truck will be higher. In the first year they are expected to be $3,000, and this amount is expected to increase by $1,500 a year through the eighth year. In year 4 the engine will need to be rebuilt, and this will cost the company $15,000 in addition to the maintenance costs in that year. At the end of 8 years the Bulldog truck will have an estimated scrap value of $5,000.
·         The last bidder, Best Tractor and Trailer Company, has agreed to sell trucks at $44,000 each. Maintenance costs in the first 4 years are expected to be $4,000 the first year and to increase by $1,000 a year. For the city’s purposes, the truck has a life of only 4 years. At that time it can be traded in for a new Best Truck, which is expected to cost $52,000. The likely trade-in value of the old truck is $15,000. During years 5 through 8 the second truck is expected to have maintenance costs of $5,000 in year 5, and these are expected to increase by $1,000 each year. At the end of 8 years the second truck is expected to have a resale or salvage value of $18,000.

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