1. Assume that you short-sell 50 shares of a stock at a price of $100 a share, p
ID: 2802216 • Letter: 1
Question
1. Assume that you short-sell 50 shares of a stock at a price of $100 a share, putting up $4,000 cash and borrowing $1,000 at an interest rate of 5%. If, after one year, the price fell to $70 and a dividend of $5/share was paid, what would be your return on investment?
2. Assume that Orange Inc. has earnings before interest and taxes totaling $100 million and is expected to grow 5% in the future by investing 25% of their pretax cash flow annually. The firm reported depreciation of $4 million, debt totaling $20 million and pays 10% on that debt (which is the same as their cost of equity). The company’s effective tax rate is 30%. Use the free cash flow approach to value the firm’s equity.
Explanation / Answer
Value of portfolio at beginning = 50*100= 5000$
Outflow at the end of period= 1000*0.05= 50$ = Interest
Dividend lost=. 5*50= 250$
Value of portfolio at end = 70* 50= 3500$
Return= 5000-3500-250-50= 1200$
Amount invested = 4000$
1200/4000*100= 30%
2. EBIT= . 100
Less: interest . (2)
EBT. 98$ million
EAT. . 68.6$ million
Add: depreciation tax shield. 1.2$ million
Less: capex(100-2*0.25). (24.5)$ million
Free cash flow to equity. 45.3$ million
Value of firm for equity stake holders. = 45.3/0.10-0.05= 906$ million.
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