AFIN 102 Group Assignment Session 2, 2017 1 Group Assignment AFIN 102 Due: 5pm on Friday, 20th October, 2017 Please use the excel template in organizing your calculation, and filling the intermediate information. It guides you to the final answer. Feel free to put more tables or calculation in the excel sheet if necessary for your solution. Question 1: Project Valuation After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread, and must decide whether to make the investment necessary to produce and market it. The tire would be ideal for drivers doing a large amount of wet weather and offroad driving in addition to normal freeway usage. The research and development costs so far have totaled about $10 million. The SuperTread would be put on the market beginning this year, and Goodweek expects it to stay on the market for a total of four years. Test marketing costing $5 million has shown that there is a significant market for a SuperTread-type tire. As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment. Except for the initial investment that will occur immediately, assume all cash flows will occur at year-end. Goodweek must initially invest $160 million in production equipment to make the SuperTread. This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the SuperTread to two distinct markets: 1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large automobile companies (like General Motors) that buy tires for new cars. In the OEM market, the SuperTread is expected to sell for $41 per tire. The variable cost to produce each tire is $29. 2. The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; Goodweek expects to sell the SuperTread for $62 per tire there. Variable costs are the same as in the OEM market. Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will also increase at 1 percent above the inflation rate. In addition, the SuperTread project will incur $43 million in marketing and general administration costs the first year. AFIN 102 Group Assignment Session 2, 2017 2 This cost is expected to increase at the inflation rate in the subsequent years. Goodweek’s corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. The company uses a 13.4 percent discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 6.2 million new cars this year and production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market. Industry analysts estimate that the replacement tire market size will be 32 million tires this year and that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8 percent market share. The appropriate depreciation schedule for the equipment is the seven-year straight-line depreciation schedule. The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15 percent of sales. What are the NPV, payback period, discounted payback period, IRR, and PI on this project? (8 marks) Question 2: Stock Valuation Larissa has been talking with the company’s directors about the future of East Coast Yachts. To this point, the company has used outside suppliers for various key components of the company’s yachts, including engines. Larissa has decided that East Coast Yachts should consider the purchase of an engine manufacturer to allow East Coast Yachts to better integrate its supply chain and get more control over engine features. After investigating several possible companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility. She has asked Dan Ervin to analyze Ragan’s value. Ragan Engines, Inc., was founded nine years ago by a brother and sister—Carrington and Genevieve Ragan—and has remained a privately owned company. The company manufactures marine engines for a variety of applications. Ragan has experienced rapid growth because of a proprietary technology that increases the fuel efficiency of its engines with very little sacrifice in performance. The company is equally owned by Carrington and Genevieve. The original agreement between the siblings gave each 150,000 shares of stock. Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan has gathered the following information about some of Ragan’s competitors that are publicly traded: AFIN 102 Group Assignment Session 2, 2017 3 EPS DPS Stock Price ROE R Blue Ribband Motors Corp. $1.19 $0.19 $16.32 10.00% 12.00% Bon Voyage Marine, Inc. $1.26 $0.55 $13.94 12.00% 17.00% Nautilus Marine Engines -$0.27 $0.57 $23.97 N/A 16.00% Industry average $0.73 $0.44 $18.08 11.00% 15.00% Nautilus Marine Engines’s negative earnings per share (EPS) were the result of an accounting write-off last year. Without the write-off, EPS for the company would have been $2.07. Last year, Ragan had an EPS of $5.35 and paid a dividend to Carrington and Genevieve of $320,000 each. The company also had a return on equity of 21 percent. Larissa tells Dan that a required return for Ragan of 18 percent is appropriate. a) Assuming the company continues its current growth rate, what is the value per share of the company’s stock? (1 mark) b) Dan has examined the company’s financial statements, as well as examining those of its competitors. Although Ragan currently has a technological advantage, Dan’s research indicates that Ragan’s competitors are investigating other methods to improve efficiency. Given this, Dan believes that Ragan’s technological advantage will last only for the next five years. After that period, the company’s growth will likely slow to the industry average. Additionally, Dan believes that the required return the company uses is too high. He believes the industry average required return is more appropriate. Under Dan’s assumptions, what is the estimated stock price? (1 mark) c) What is the industry average price–earnings ratio? What is Ragan’s price–earnings ratio? Comment on any differences and explain why they may exist. (1 mark) d) Assume the company’s growth rate declines to the industry average after five years. What percentage of the stock’s value is attributable to growth opportunities? (1 mark) e) Assume the company’s growth rate slows to the industry average in five years. What future return on equity does this imply? (1 mark) f) Carrington and Genevieve are not sure if they should sell the company. If they do not sell the company outright to East Coast Yachts, they would like to try and increase the value of the company’s stock. In this case, they want to retain control of the company and do not want to sell stock to outside investors. They also feel that the company’s debt is at a manageable level AFIN 102 Group Assignment Session 2, 2017 4 and do not want to borrow more money. What steps can they take to try and increase the price of the stock? Are there any conditions under which this strategy would not increase the stock price? (1 mark) Question 3: The Fama-French Multifactor Model and Mutual Fund Returns Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read several articles concerning the risk factors that can potentially affect asset returns, and she has decided to examine Jack’s mutual fund holdings. Jack is currently invested in the Fidelity Magellan Fund (FMAGX), the Fidelity Low-Priced Stock Fund (FLPSX), and the Baron Small Cap Fund (BSCFX). Dawn would like to estimate the well-known multifactor model proposed by Eugene Fama and Ken French to determine the risk of each mutual fund. Here is the regression equation for the multifactor model she proposes to use: ???????????? – ???????????? = ???????? + ????1(???????????? – ????????????) + ????2(????????????????) + ????3(????????????????) + ???????? In the regression equation, ???????????? is the return on Asset i at Time t, ???????????? is the risk-free rate at Time t , and ???????????? is the return on the market at Time t. Thus, the first risk factor in the Fama–French regression is the market factor often used with the CAPM. The second risk factor, SMB, or “small minus big,” is calculated by taking the difference in the returns on a portfolio of small-cap stocks and a portfolio of big-cap stocks. This factor is intended to pick up the so-called small firm effect. Similarly, the third factor, HML, or “high minus low,” is calculated by taking the difference in the returns between a portfolio of “value” stocks and a portfolio of “growth” stocks. Stocks with low market-to-book ratios are classified as value stocks and vice versa for growth stocks. This factor is included because of the historical tendency for value stocks to earn a higher return. In models such as the one Dawn is considering, the alpha (a) term is of particular interest. It is the regression intercept; but more important, it is also the excess return the asset earned. In other words, if the alpha is positive, the asset earned a return greater than it should have given its level of risk; if the alpha is negative, the asset earned a return lower than it should have given its level of risk. This measure is called “Jensen’s alpha,” and it is a very widely used tool for mutual fund evaluation. AFIN 102 Group Assignment Session 2, 2017 5 a) For a large-company stock mutual fund, would you expect the betas to be positive or negative for each of the factors in a Fama–French multifactor model? (1 mark) b) The Fama–French factors and risk-free rates are available at Ken French’s website: www.dartmouth.edu/~kfrench . Download the monthly factors and save the most recent 60 months for each factor. The historical prices for each of the mutual funds can be found on various websites, including finance.yahoo.com. Find the prices of each mutual fund for the same time as the Fama–French factors and calculate the returns for each month. Be sure to include dividends. For each mutual fund, estimate the multifactor regression equation using the Fama–French factors. How well do the regression estimates explain the variation in the return of each mutual fund? (2 marks) c) What do you observe about the beta coefficients for the different mutual funds? Comment on any similarities or differences. (1 mark) d) If the market is efficient, what value would you expect for alpha? Do your estimates support market efficiency? (1 mark) e) Which fund has performed best considering its risk? Why? (1 mark) Administrative requirements This report is worth 20% of the course’s marks. Please submit both your report and the excel file supporting your report. You should form a group of 2-4 members from any class. You may not make a group of more than 4 or less than 2. Each group member must contribute substantially to the final submitted work. Groups can be amongst students from any class. Your group must elect a leader. The team leader is expected to maintain a weekly journal, registering the contribution of each team member during the week. The journal must be submitted with the assignment. It need not be exhaustive, just a record of significant contributions. All group members are equally responsible for the entire submitted assignment. You can choose your own group members. You can eject non-contributing members from your group, but this must be done at least 10 calendar days before submission and you must tell the group member, preferably by email using your MQ email accounts, that they’re ejected at this AFIN 102 Group Assignment Session 2, 2017 6 time so they can begin the work themselves. The ejected group members may not use the old group’s work that they did not contribute to. The limit is 10 pages using 1.5 line spacing and default margins, just like this page. Supporting images, graphs, tables and so on should be placed in-text next to the paragraph where the figure is discussed. There’s no need for an appendix and if you have one it’s not likely to be marked. You may use any common referencing style you like. Bibliographies are not included in the page count. Items listed in the bibliography but not actually referred to in the report will have marks deducted. The assignment should be submitted in electronic form to Turnitin which will be made available as a link online. Assignments that are not proof-read will be marked down. Grammar and sentence structure is important. Business writing should be clear, succinct and front-focused, which means putting the most important points at the very start. Answer the questions in the order that they are asked. Be sure to include sub-headings that contain the question number. There’s no need for an introduction or conclusion. This assignment is a collection of short answer questions. There’s no need to write the whole question in your assignment if you’re struggling to fit everything into the page limit. You may write the question number as a subtitle to show where each question begins. For example: Question 1: Write answer here.