Managerial Finance
FIN 350
ALLIANCE STOCK FUND ANALYSIS
Mini Case Study
Points: 5
Name: __________________________________
A recent inheritance from your late uncle’s estate has provided you with funds available
for investment. You have been provided with the following information for three stocks: Stocks
X, Y, and Z.
Stock
Expected Return
Standard Deviation
Beta
X
Y
Z
8.00%
9.50%
13.50%
15%
15%
15%
0.5
0.9
1.4
The returns on the three stocks are positively correlated, but they are not perfectly correlated.
(I.e., each of the correlation coefficients is between 0 and 1.0.) There are two diversified stock
funds available into which you could invest your inheritance funds:
❑
Fund P has thirty percent of its funds (30%) invested in Stock X and seventy percent
(70%) invested in Stock Y.
❑
Fund Q has one-third (33.33%) of its funds invested in each of the three stocks.
The risk-free rate (R F ) is 3.5%, and the market is in equilibrium. (I.e., the required returns
equal the expected returns.) The market average rate of return ( r m ) is 8%.
1. What is the portfolio beta for each of the available stock funds?
a. Fund P:
b. Fund Q:
2. What is the generic equation for the Security Market Line (SML) that would apply to all
publicly-traded stock shares, using the numerical values given for the risk-free rate ( R F ) and
the market average rate of return ( r m ) that are provided in the case study above?
3. Using the Security Market Line (SML) equation that you developed in Question #2 above,
calculate the required rate of return on each of the available stock funds:
a. Fund P:
b. Fund Q:
4. Based on your calculations, which stock fund appears to be most risky? Why?
5. Into which fund would you invest your inheritance funds? Why?
2
Mini Case Study: HINTS
Alliance Stock Fund
The Alliance Stock Fund mini case study also focuses on the Security Market Line
(SML) equation.
In Question #1 of this case study, you would calculate the beta of each portfolio using the
information provided on page one of this case study. Note that the weight of each stock within
each portfolio is provided for you in the case study. I.e., for Fund P, thirty percent of the funds (
.3 ) are invested in Stock X and seventy percent of the funds ( .7 ) are invested in Stock Y. For
Fund Q, one-third of the funds ( .3333 ) are invested in each of the three stocks. Note that you
can total these “weight” percentages for the stocks within a given portfolio together. If your
calculations have been done correctly, these percentages should total to 100%.
You would then use the formula shown at the top of page 352 of the textbook to calculate the
beta for each portfolio.
bp =
n
wj X bj
j =1
I.e., for each of the portfolios, you would multiply the portion of money invested in each
security by the beta for that security. You would then sum together the results of these
multiplication operations to calculate the beta for the portfolio. For Fund P, there would be two
multiplication operations, as Fund P consists of only two securities. For Fund Q, there would be
three multiplication operations, as Fund Q consists of three securities.
In Question #2, you are asked to identify the generic SML equation based on the data provided in
this mini case. The numerical values for the risk-free rate of return ( R F ) and the market rate of
return ( r m ) are provided for you on page one of this case study. You can substitute these
values into the Security Market Line (SML) equation:
rj
=
RF
+
( r m - R F) b j
The only variables that would then remain as a letter variable for the generic version of this
Security Market Line (SML) equation are beta ( b j ) and the required rate of return ( r j ).
In Question #3, you would substitute the beta that you calculated for Fund P in Question #1 into
the SML equation that you formulated in Question #2 of this case study. When you solve this
SML equation, you will calculate the required rate of return on this portfolio: r p . I.e., this
“required” rate of return is the minimum acceptable rate of return, given the level of risk of this
portfolio as measured by the portfolio’s beta. You would then substitute the beta that you
calculated for Fund Q in Question #1 into the SML equation that you formulated in Question #2
to calculate the required rate of return on this portfolio: r Q .
3
ENTERTAINMENT, INC.
Mini Case Study
The Computer Games Division of Entertainment, Inc. is considering two investment projects, each of
which has an up-front expenditure of $30,000. You estimate that the cost of capital is 9 percent and that the
investments will produce the following after-tax cash inflows:
Year
Project A
Project B
1
2
3
4
6,000
12,000
16,000
22,000
22,000
16,000
12,000
6,000
Prepare answers to the following questions. Please show your calculations.
1. What is the payback period for each of the projects?
2.
What is the Net Present Value (NPV) for each of the projects?
3. If the two projects are independent and the cost of capital is 9 percent, which project or projects should
Entertainment, Inc. undertake?
4. If the two projects are mutually exclusive and the cost of capital is 9 percent, which project should
Entertainment, Inc. undertake? (Hint: With mutually exclusive projects – a situation in which only one of
the two projects could be done, but not both – the NPV method provides the theoretically best answer.)
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Mini Case Study: Entertainment, Inc.
HINTS
In this mini case study, you are presented with two possible projects: Project A and
Project B. In Question #1, you would calculate the payback period for each of these projects,
using the methodology described in Problem #P10-3 above. In Question #2, you would calculate
the NPV for each of these projects using the methodology described in Problem #P10-10 above.
The decision criteria for accepting or rejecting a project, based on its NPV calculations,
are found on Slide #36 of the Chapter Ten Powerpoint outline. This Powerpoint outline is
available at the “Content” link at our course Web site.
In Question #3 of this mini case, you are asked to select the project(s) that should be done,
assuming the projects are “independent.” Independent projects have no relationship to one
another. I.e., this would not be an “either/or” situation. Both projects could be done if both
projects meet the NPV decision criteria specified on Slide #36 of the Chapter Ten Powerpoint
outline.
In Question #4 of this mini case, you are asked to select the project that should be done,
assuming the projects are “mutually exclusive.” With mutually exclusive projects, only one
project can be done, not both. Therefore, you would select the project that has the highest NPV,
as that project will add the most value to the firm.
MINI CASE: BREAKEVEN POINT
Martin Corporation
Possible Points: 5
Martin Corporation sells component parts for the electronics industry. Martin Corporation currently sells
160,000 units per year at a price of $6.50 per unit; its variable cost is $4.00 per unit; and fixed costs are
$350,000 for the year. Martin is considering expanding into two additional states, which would increase its fixed
costs to $570,000 and would increase its variable unit cost to an average of $4.24 per unit. If Martin expands, it
expects to sell 250,000 units at $7.10 per unit.
1. How much operating profit (EBIT) is Martin Corporation currently realizing, with a sales volume of
units per year?
a. What is Martin Corporation’s current breakeven point in terms of:
1. Quantity:
2. Sales Dollars:
5
160,000
2. How much operating profit (EBIT) would Martin Corporation realize under the expansion proposal?
a. What would be Martin’s new breakeven point in terms of:
1. Quantity:
2. Sales dollars:
3. Based on the above analysis, what recommendation would you make to Martin Corporation with
regard to their proposed expansion plan?
Mini Case Study: HINTS
Martin Corporation
In Question #1 of this mini case, you would calculate the “Earnings Before Interest and
Taxes” (EBIT) that Martin Corporation will realize at its current sales volume of 160,000 units
per year. The formula that you would use to complete this calculation appears at the bottom of
page 508 in your textbook:
EBIT = (P X Q) - FC - (VC X Q)
P = Selling price per unit
Q = Quantity expected to be sold during the year
FC = Total fixed costs for the year
VC = Variable cost per unit
In Question #1.a.1. of this mini case, given the variables that you have identified in Question
#1, you would calculate the breakeven quantity (Q) using the formula that appears at the center
of page 509 of the textbook.
6
Q =
FC
(P - VC)
“Q” is the breakeven point in units. This number represents the unit volume that must be sold
during the coming year to cover the firm’s fixed costs and variable costs.
In Question #1.a.2., you can calculate the breakeven point in sales dollars by multiplying the
breakeven quantity that you calculated in Question #1.a.1. by the selling price per unit as
follows:
Q X P = Breakeven point in sales dollars.
In Question #2, you would use the same formula as shown in Question #1 above, but assume
an annual volume of 250,000 units. Be sure to adjust the numerical values of the other variables
as noted in the first paragraph of this case study.
EBIT = (P X Q) - FC - (VC X Q)
In Question #2.a.1, you would calculate the new breakeven quantity, based on the new values
for the cost variables that you identified in Question #2.
Q =
FC
(P - VC)
In Question #2.a.2, you would calculate the new breakeven point in sales dollars, based on the
new breakeven quantity in units that you calculated in Question #2.a.1.
Q X P = Breakeven point in sales dollars.
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