Assigment 3: Ownership Considered Equity And Ownership Considered Debt

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University of La Verne
College of Business & Public Management
Business Finance 500D Online
Winter 2013
Assignment #3
This work is due on Sunday February 24 @ Midnight in the Assignment #3 folder of Blackboard. Please post your work file, with your name in the file title, to the Assignment #3 folder in Blackboard.

Question #1: (Twenty Points)
Stocks
(a). Why is stock ownership considered equity and bond ownership considered debt?

In finance you can think of equity as ownership in any asset after all debts associated with that asset are paid off. For example, a car or house with no outstanding debt is considered the owner's equity because he or she can readily sell the item for cash. Stocks are equity because they represent ownership in a company. When a company needs money, the solution is to raise money by issuing bonds to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).

(b). I am considering buying a stock, the stock has a beta coefficient of 1.5, the current risk free rate in the market place (10 year T-Notes) is 3.0%, and the market risk premium is 5%. What is the required rate of return on this firm’s stock?

Βstock = 1.5
RFR = .003
Rmarket = .05
E(R) = the required rate of return

E(R) = RFR + βstock (Rmarket – RFR)
E(R) = 0.03 + 1.5 (0.05 – 0.03)
E(R) = 0.03 + 1.5 (0.02)
E(R) = 3.06%

Question #2: (Twenty Points)
Sexton Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. Please determine the NPV, IRR, Profitability Index and Payback for these two Projects.

WACC: 10.25%
Year 0 1 2 3 4
CFS -$2,050 $ 750 $ 760 $ 770 $ 780
CFL -$4,300 $1,500...
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