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GigaTech Inc. is a large U .S .-based technology conglomerate. The firm has business units in three primary categories: hardware manufacturing, software development, and consulting services. Because of the rapid pace of technological innovation, GigaTech must make capital investments every two to four years. The company has identified several potential investment opportunities for its hardware manufacturing division. The first of these opportunities, Tera Project, would replace a portion of GigaTech's microprocessor assembly equipment with new machinery expected to last three years. The current machinery has a book value of $120,000 and a market value of $195,000. Tcra Project would require purchasing machinery for $332,000, increasing current assets by 5190,000, and increasing current liabilities by $80,000. GigaTech has a tax rate of 40%. Additional pro forma information related to the Tera Project is provided in the following table:

Analysts at GigaTech have noted that investment in the Tera Project can be delayed for up to nine months if managers at the company decide this is necessary. However, once the capital investment is made, the project will be necessary to maintain continuing operations. Tera Project can be scaled up with more equipment requiring less capital than the original investment if results are meeting expectations. In addition, the equipment used in Tera Project can be used in shift work if brief excess demand is expected.
GigaTech is also considering expanding its software development operations in India. Software development equipment must be continually replaced to maintain efficiency as newer and faster technology is developed. The company has identified two mutually exclusive potential expansion projects, Zeta and Sigma. Zeta requires investing in equipment with a 3-year life, while Sigma requires investing in equipment with a 2-year life. GigaTech has estimated real capital costs for the two projects at 10.58%. GigaTech expects inflation to be approximately 4.0% for the foreseeable future. Nominal cash flows and net present values for the Zeta and Sigma projects are provided in the following table

Recently, GigaTechs board of directors has become concerned with the firm's capital budgeting decisions and has asked management to provide a detailed explanation of the capital budgeting process. After reviewing the report from management, the board makes the following comments in a memo:
* The capital rationing system being utilized is fundamentally flawed since, in some instances, projects that do not increase earnings per share are selected over projects that do increase earnings per share.
* The cash flow projections are flawed since they fail to include costs incurred in the search for projects or the economic consequences of increased competition resulting from highly profitable projects.
* We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.
Using the least common multiple of lives approach, determine whether the Zeta Project or the Sigma Project will increase the value of GigaTech by a greater amount.

Evermore also uses the interest rate tree to estimate the option-adjusted spreads of two additional callable corporate bonds, as shown in the following figure.

Evermore concludes, based on this information, that the A A-rated issue is undervalued, and the BB-rated issue is overvalued.
At a subsequent meeting with the trustees of the fund. Evermore is asked to explain what a binomial interest rate model is and how it was used to estimate effective duration and effective convexity. Evermore is uncertain of the exact methodology because the actual calculations were done by a junior analyst, but she tries to provide the trustees with a reasonably accurate step-by-stcp description of the process:
Step 1: Given the bond's current market price, the on-the-run Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree.
Step 2: Add 100 basis points to each of the 1-year rates in the interest rate tree to derive a 'modified' tree.
Step 3: Compute the price of the bond if yield increases by 100 basis points using this new tree.
Step 4: Repeat Steps 1 through 3 to determine the bond price that results from a 100 basis point decrease in rates.
Step 5: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.
Lucas Davenport, a trustee and university finance professor, immediately speaks up to disagree with Evermore. He claims that a more accurate description of the process is as follows:
Step 1: Given the bond's current market price, the Treasury yield curve, and an assumption about rate volatility, create a binomial interest rate tree and calculate the bond's option-adjusted spread (OAS) using the model.
Step 2: Impose a parallel upward shift in the on-the-run Treasury yield curve of 100 basis points.
Step 3: Build a new binomial interest rate tree using the new Treasury yield curve and the original rate volatility assumption.
Step 4: Add the OAS from Step I to each of the 1-year rates on the tree to derive a 'modified' tree.
Step 5: Compute the price of the bond using this new tree.
Step 6: Repeat Steps 1 through 5 to determine the bond price that results from a 100 basis point decrease in rates.
Step 7: Use these two price estimates, along with the original market price, to calculate effective duration and effective convexity.
At the meeting with the trustees. Evermore also presents the results of her analysis of the effect of changing market volatilities on a 1-year convertible bond issued by Highfour Corporation. Each bond is convertible into 25 shares of Highfour common stock. The bond is also callable at 110 at any time prior to maturity. She concludes that the value of the bond will decrease if either (1) the volatility of returns on'Highfour common stock decreases or (2) yield volatility decreases.
Davenport immediately disagrees with her by saying 'changes in the volatility of common stock returns will have no effect on the value of the convertible bond, and a decrease in yield volatility will result in an increase in the value of the bond.'
What are the benchmark interest rates Evermore uses to estimate the option-adjusted spreads?

Millennium Investments (MI), an investment advisory firm, relies on mean-variance analysis to advise its clients. Mi's advisors make asset allocation recommendations by selecting the mix of assets along the capital allocation line that is most appropriate for each client.

One of MPs clients, Edward Alverson, 60 years of age, requests an analysis of four risky mutual funds (Fund W, Fund X, Fund Y, and Fund Z). After examining the four funds, MI finds that all four mutual funds are equally weighted portfolios, and that all of the funds, except Fund Z, are mean-variance efficient. MI also finds that the correlations between all pairs of the mutual funds are less than one.

MI calculates the average variance of returns across all assets within each mutual fund, the average covariance of returns across all pairs of assets within each mutual fund, and each mutual fund's total variance of returns. The results of Mi's calculations are reported in Exhibit 1.

James Kelley is the CFO of X-Sport Inc., a manufacturer of high-end outdoor sporting equipment. Using both debt and equity, X-Sport has been acquiring small competitor companies rather rapidly over the past few years, leading Kelley to believe that the firm's capital structure may have drifted from its optimal mix. Kelley has been asked by the board of directors to evaluate the situation and provide a presentation that includes details of the firm's capita! structure as well as a risk assessment. In order to assist with his analysis, Kelley has collected information on the current financial situation of X-Sport. He has also projected the financial information for alternative financing plans. This information is presented in Exhibit 1.

After carefully analyzing the data, Kelley writes his analysis and proposal and submits the report to Richard Haywood, the chairman and CEO of X-Sport Inc. Excerpts from the analysis and proposal follow:
* In selecting a re-financing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current Baa rating, causing our cost of debt to rise dramatically. This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest tax shield will be more than The marginal increase in the costs of financial distress. However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of X-Sport management with its shareholders.
* In the event that X-Sport decides to proceed with a recapitalization plan, I recommend Plan D since it is the most consistent with the shareholders' interests.
Haywood reviews the report and calls Kelley into his office to discuss the proposal. Haywood suggests that Flan B would be the most appropriate choice for adjusting X-Sport's capital structure. Before Kelley can argue, however, the two are interrupted by a previously scheduled meeting with a supplier.
Haywood takes Kelley's data and proposes to the board of directors that X-Sport pursue one of three alternatives to restructure the company. The first alternative is Plan B from Kelley's analysis. The second alternative involves separating GearTech, one of the companies acquired over the last few years, from the rest of the company by issuing new GearTech shares to X-Sport common shareholders. The third alternative involves creating a new company, Euro-Sport, out of the firm's European operations and selling 35% of the new Euro-Sport shares to the public while retaining 65% of the shares within X-Sport. After some persuading, Haywood convinces the seven-member board (two of whom were former executives at GearTech) to accept the second alternative, which he had favored from the beginning. The board puts together an announcement to its shareholders as well as the general public, detailing the terms and goals of the plan.
A group of shareholders, upset about the board's plan, submit a formal objection to X-Sport's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of the company and its shareholders. The objection also states that:
* The value of X-Sport's common stock has been impaired as a result of the poor corporate governance system.
* The liability risk of X-Sport has increased due to the increased possibility of future transactions that benefit X-Sport's directors, without regard to the long-term interests of shareholders.
* The asset risk of X-Sport has increased due to the inability of investors to trust the GearTech financial disclosures necessary to value the division.
Which of the following best explains the difference between X-Sport's current cost of debt and the cost of debt associated with Plan A?