1) Suppose a financial market analyst knows that Pandemonium, Inc. will be in bu
ID: 2538786 • Letter: 1
Question
1) Suppose a financial market analyst knows that Pandemonium, Inc. will be in business for at least five years and have the following cash flows per share:
Year 1 Year 2
Revenue $400 $400
Costs $285 $285
Net Cash $115 $115
A) What is the stock price of Pandemonium, Inc. if the opportunity cost of capital is 4%?
B) Now suppose the $285 costs are uncertain due to the possibility of a liability suit for wrongful injury. Further assume there is a 10% chance of a lawsuit with an expected additional cost of $5 per share.
a) What is Pandemonium’s expected net cash flow in each year?
b) If the opportunity cost of capital is 4%, what is the stock price?
C) Should the opportunity cost of capital change (i.e., be different from 4%) due to the risk of a wrongful death loss?
D) Suppose Pandemonium purchases special liability insurance to cover the type of wrongful death exposure it faces. The premium for full coverage (no deductible) is $0.80 per share. What is the stock price?
2) Delish Restaurants has assets worth $50 million. If these assets are destroyed, Delish plans to replace them at a cost of $50 million. Delish uses the straight-line depreciation method and the assets have a two-year depreciable lifespan. For tax purposes, the assets have already been depreciated to zero. Assume the probability the assets will be destroyed during the coming year equals 0.05, the income tax rate is 34%, and the capital gains tax rate is 28%. Calculate the expected tax shield generated from the property in the coming year and future years if:
A) Delish plans to use internal funds to finance replacement of the property in the event it is destroyed.
B) The company purchases replacement cost insurance for a premium of $2.5 million and plans to recognize a capital gain if the insurance proceeds are used to replace the property.
C) Delish purchases replacement cost insurance for a premium of $2.5 million and plans to defer the capital gain if the insurance proceeds are used to replace the property.
Explanation / Answer
1. (A) Stock price = 115/1.04 + 115/(1.04)^2 = $216.90
1. (B)
(a) Year 1 Year 2
Revenue 400 400
Cost 285 with 0.9 prob 285 with 0.9 prob
290 with 0.1 prob 290 with 0.1 prob
Net cashflow 115 with 0.9 prob 115 with 0.9 prob
110 with 0.1 prob 110 with 0.1 prob
Expected net cashflow = 115*0.9 + 110*0.1 = $114.50
(b) Stock price = 114.50/1.04 + 114.50/(1.04)^2 = $215.96
(C) No, the opportunity cost of capital should not change as it is a case of specific risk which can be difversified away by the shareholders, so no additional return is given for any specific risk.
(D)
Year 1 Year 2
Revenue 400 400
Cost 285+0.8 with 0.9 prob 285+0.8 with 0.9 prob
290+0.8-5 with 0.1 prob 290+0.8-5 with 0.1 prob
Net cashflow 400-285.8 400-285.8
Expected net cashflow = 400 - 285.80 = $114.20
Stock price = 114.20/1.04 + 114.20/(1.04)^2 = $215.39
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