George Tannous – Comm 363 – Intermediate Corporate Finance – September 2015 – Assignment 1 1/3

1. Night Life Fashions (NLF) has been trading on the Toronto Stock Exchange (TSX) for more than 20 years.
NLF’s year-end prices and dividends and the TSX index level over the past 6 years are listed in Table 1:

Table 1: NLF’s share prices and dividends and the TSX index over the past several years
December 31 2010 2011 2012 2013 2014 2015
Share Price 52.67 64.86 63.04 68.71 79.75 65.15
Dividend 0.83 0.95 0.95 1.00 1.00 1.05
TSX Index 9546 11044 10887 13128 15586 13618
NLF Returns
TSX Returns

a) What are the arithmetic mean return and the geometric mean return for NLF for the last 5-year period? (7
marks)

b) Using the arithmetic average, what is the standard deviation for NLF’s returns? (3 marks)

c) What are the TSX market returns for past 5 years? (4 marks)

d) Assuming the TSX is the market against which you measure the risk of NLF, what is the beta of NLF and
the correlation coefficient between NLF and the market? (4 marks) Hint: You need to use excel or your
calculator for this exercise. In Excel: (1) arrange the NLF returns and the TSX returns in two columns. (2)
in excel go to data, data analysis, from the table highlight regression, and OK. A table with instructions
appears. (3) Follow the directions. Make sure to enter the NLF returns data as the Y Range data and the
TSX returns data as the X Range. The beta will be the coefficient of Variable 1.

2. You have $128,000 to invest and you wish to divide this amount between three securities: $48,000 in the shares
of Firm A, $38,400 in the shares of Firm B, and the remaining part in the risk free asset. You collected the
following information:

Return if the state occurs

State of the Probability of Share A Share B Risk-free asset Inflation rate
economy Occurrence
Boom 0.05 0.25 0.35 0.06 0.040
Normal 0.65 0.18 0.14 0.04 0.025
Recession 0.30 -0.06 -0.15 0.02 0.010

a) What is the expected return on the portfolio? (7 marks)

b) What is the standard deviation of the return on the portfolio? (4 marks)

c) What is the expected risk premium on the portfolio? (3 marks)

d) What is the expected real return on the portfolio? (3 marks)

3. You are interested in buying shares of The Mortgage Bank (TMB) and the Fresh Fruit Corporation (FFC).
Currently, TMB shares are selling at $45 per share while the shares of FFC are selling at $52 per share. Neither
TMB nor FFC pays dividends. Your analysis suggests that in a year from today TMB shares are expected to
reach $50.04 while the shares of FFC are expected to rise to $58.76. You estimate the betas to be 0.82 for TMB
and 1.45 for FFC. In addition, you find that financial analysts agree that over the next year, the risk-free rate is
expected to be 4% while the expected return on the TSX composite index will be 12%.

a) What is the required rate of return on each of TMB and FFC? (3 marks)

b) If you want to invest in TMB or in FFC but not both, which one would you choose and why? (4 marks)
George Tannous – Comm 363 – Intermediate Corporate Finance – September 2015 – Assignment 1 2/3

c) You decided to purchase 300 shares of FFC and 400 shares of TMB. What will be the beta of your
portfolio? (4 marks)

d) What portfolio of FFC and TMB will have a beta of 1.00? Hint: You need to find the weight of each
security in this portfolio. (4 marks)

4. The capital structure of Balanced Pressure Mattress (BPM) consists of common shares, preferred shares, and
bonds. BPM has 10 million common shares outstanding and the current share price is $22.5. BPM just paid
(September 20, 2015) a dividend of $0.66 per share. The company has paid dividends per share as follows:
$0.55 on September 20, 2014, $0.52 on September 20, 2013, $0.50 on September 20, 2012, and $0.44 on
September 20, 2011. BPM has 5.2 million preferred shares outstanding with par value of $10 each but the
current market price is $15. Each preferred share pays $1.8 in annual dividends. Finally, BPM has $200 million
face value in outstanding debt. The debt matures in 15 years and pays 7% coupon payments semi-annually. The
market value of the debt is $985 per $1000 face value. BPM’s corporate tax rate is 25%.

a) What is the cost of common equity capital for BPM? (5 marks) Hint: Use the arithmetic mean to estimate
the growth rate of dividends.

b) What is the cost of preferred share capital? (2 marks)

c) What is the after-tax cost of debt capital? (5 marks)

d) What are the weights of each source of capital? (5 marks)

e) What is the WACC? (2 marks)

5. Integrated Gas Resources (IGR) is considering three projects P1, P2, and P3. The budgeting manager, Ashley,
estimates the betas of these projects and their expected returns (the Internal Rates of Return) as follows:

Project P1 P2 P3
Beta 1.60 1.10 0.68
IRR 18% 16% 13%

Being a market expert, you advise Ashley that the expected return on the market is15% and the risk-free rate is
expected to be 6%. Ashley determines IGR’s WACC to be 14%.

a) If the firm ignores risk and uses the WACC as a cut off rate for acceptance or rejection, which projects
would be accepted? (3 marks)

b) Considering risk, which projects should be accepted and which should be rejected? Explain why. (6 marks)

6. Integrated Gas Resources (IGR) is trying to determine its cost of capital from preferred shares. It has two types
of preferred shares. There are 1,000,000 Class A preferred shares outstanding currently trading at $21 per share
but the book value is $20. Class A shares pay $1.68 in dividends per year. Also, IGR has 500,000 Class B
preferred shares outstanding currently trading at $16 per share. The book value per share is $15 and the annual
dividend per share is $1.12. What is IGR’s cost capital from preferred shares? (10 marks)
George Tannous – Comm 363 – Intermediate Corporate Finance – September 2015 – Assignment 1 3/3

7. You determined that the returns from Horizontal Transportation (HT) are normally distributed with a mean of
9% and standard deviation of 8%. In addition, you are confident that past returns are good indicators of future
returns. If you buy shares in HT.

a) What is the probability that your return will be below -7%? (2 marks)

b) What is the probability that your return will be above 17%? (2 marks)

c) What is the probability that your return will be between 9% and 17%? (3 marks)

8. Which of the following statements is correct? (3 marks)

a) Upon the public announcement of finding gold in Field X owned by Saskatoon Gold Minerals (SGM),
the shares of SGM immediately soared 100% from $5 to $10 and over the next 2 days the price climbed
another dollar per day to reach $13. This event suggests that the market for SGM shares is semi-strong
efficient.
b) The first statement in Part (a) suggests that the market for SGM shares is weakly efficient.
c) The disastrous flood in Calgary few years ago is a good example of systematic risk.
d) A portfolio that has shares from 30 different internet stocks is not a well-diversified portfolio.
e) Investors who take risk will always be rewarded accordingly.

9. Fill the blank spaces if the following two statements

a) The derailment of a long train hauling oil from Alberta to the United States is a good example of
____________________________________ risk. (1 mark)

b) __________________________________________ is a statistical measure that indicates the relative

volatility of the price of an asset (stock, bond, ounce of gold, or other security) in comparison with the
volatility of the market as a whole. (1 mark)