MarketingEngineering Management 535
Dr. Stephen V. Smith
1. Assume that you are in the 40% federal-plus-state marginal tax bracket and that capital gains taxes are deferred until maturity. Assuming equal investment risk and a horizontal yield curve, rank the following investment opportunities on the basis of the effective annual yields:
a. A $100 par value perpetual preferred stock with an annual coupon of 12%, quarterly payments, and selling at $105.
b. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 12% currently selling at $1,050.
c. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 6% selling at a price of $637.
d. How would the situation change if the ranker had been:
1) a pension fund investment manager or
2) a corporation that is in the 40% federal-plus-state bracket?
Part d - Explain in words but demonstrate that you could quantify your answer.
2. Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings net of dividends were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is 4 percent. If the market is in equilibrium, what is the market value of the firm's common equity (1 million shares outstanding)?
Engineering Management 535 (cont’d) Page 2.
3. Longstreet Communications, Inc. (LCI), has the following capital structure, which it considers to be optimal:
Preferred stock 15
Common stock 60
LCI’s net income expected this year is $17,142.86; its established dividend payout ratio is 30%; its tax rate is 40%; and investors expect earnings and dividends to grow at a constant...