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Unformatted text preview: MONASH UNIVERSITY LIBRARY I I II II I Hill" I  0041 1 7866
Monash University Office Use Onl Semester Two Examinations 2004  Solutions Faculty of Business and Economics EXAM CODES: AFC2140 TITLE OF PAPER: BUSINESS FINANCE
EXAM DURATION: 180 minutes writing time
READING TIME 10 minutes THIS PAPER IS FOR STUDENTS STUDYING AT: (tick where applicable) El Berwick El Clayton El Malaysia [I Distance Education '_'l Open Learning
El Caulfield El Gippsland III Peninsula I'_‘l Enhancement Studies El Other (specify) INSTRUCTIONS TO CANDIDATES: This paper contains 9 questions. Students must answer ALL questions. Begin each
question on a fresh page of the examination script book. A formula sheet is included which
can be detached. During an exam, you must not have in your possession, a book, notes, paper, calculator,
pencil case, mobile phone or other material/item which has not been authorised for the exam
or specifically permitted as noted below. Any material or item on your desk, chair or person
will be deemed to be in your possession. You are reminded that possession of unauthorised
materials in an exam is a discipline offence under Monash Statute 4.1. AUTHORISED MATERIALS CALCULATORS (in line with Faculty policy) El YES El NO
OPEN BOOK ‘ '_'l YES M NO
SPECIFICALLY PERMITTED ITEMS '_'l YES El NO if es, items ermitted are: _ , , , , .
Candidates"mUstfcompletegthisseétlohrtffrequilfed answer in ’h’sipa’i’er , STUDENT ID _.,._____...__.__,.__.___.._ ' I 'TDESKNUMBER ,___.,_..... SURNAME , r , I I r
.................... OTHER NAMES (infull) I I I _ g ' Vit!Iinf]Iltoga.lin!l‘ilgjiiwlunIclf'lllltvlllllnlllnil}.I , r Page 1 of 12 Question 1 (a) (i) IRR is the rate of return that discounts the investment projects estimated cash
flows such that their present value equates to the project’s initial outlay. 15
percent is therefore estimated to be the investment project’s unique rate of
return. The project is expected to recover its initial outlay and to return 15
percent per annum over five years to the company’s investors. (ii) BBB is the minimum rate of return required by the company’s investors from
the investment project. 10 percent per annum is the best available return that
the company’s investors can earn elsewhere with the same systematic risk as
the investment project. (b) The IRR of 15 percent can be compared to the BBB of 10 percent to determine
that the investment project is expected to generate a rate of return per annum in
excess of the minimum return required by the company’s investors. The
company should therefore proceed with the investment project because it will
increase the wealth of its investors by more than the best alternative with the
same systematic risk as the project. The BBB becomes the opportunity cost of capital to the company of using the
capital supplied by its investors to finance the investment prOject. 10'percent per
annum is therefore the benchmark rate of return against which the investment
project should be evaluated. The company needs to generate a rate of return of
at least 10 percent per annum from the investment project in order to
compensate its investors for forgoing this best available return elsewhere for the
same systematic risk as the project. Question 2 (a) NPV(Aluminia) =2§fi%gg(l  11125 )— 400,000
= $50,597.03 NPV(Shinymetal)_ =%%Qg(l — 1.1123 )— 250,000
= $38,219.75 80 choose the Aluminia machine because this choice maximises the wealth of the
firm (i.e. has the largest NPV) given the only option of purchasing each machine
once only. Page 2 of 12 (b)
Solution (i) using NPV°° 1.125
NPV(Aluminia) co =50’59703 m = $116,967.56 1.123
NPV(Shinymetal) co =38,21975 m = $132,606.29
Solution iii) using EAV $50,597.03 = EAV(Aluminia) 1_ 1
0.12 1.125 $50,597.03 = EAV(Aluminia)>< 3.6048 EAV(Auminia) = $14,036.02 $132,606.29: EAV(Shinymetal) 1_ 1
0.12 1.123 $38,219.75 = EAV(Shinymetal)>< 2.4018
EAV(Shinymetal) = $15,912.96 So choose the Shinymetai machine because this choice maximises the wealth of the
firm (i.e. has the largest NPV°° and/or EAV) given the option of continuously
replacing the machines. (c) NPV of leasing indefinitely = W = w = $166,666.66
0.12 0.12 Finco should lease because it has a higher NPV than continuously replacing the
Shinymetai machine. Page 3 of 12 Question 3 (a) Pessimistic Sales, Expected Variable Cost Net Annual Revenue (Sales=70,000, Variable Cost=$2.50)
= —$100,000 + ($4.00 — $2.50)>< 70,000 = $5,000 NPV=W(1— 1 )=$21,441.52 0.14 1.147 Optimistic Sales, Expected Variable Cost Net Annual Revenue (Sales=100,000, Variable Cost=$2.50) = —$100,000 + ($4.00 — $2.50)>< 100,000 = $50,000 NPV = $50,000 1_ 1
0.14 1.147
= $214,415.24 Pessimistic Variable Cost, Expected Sales Net Annual Revenue (Sales=85,000, Variable Cost=$3.00) = —$100,000 + ($4.00 — $3.00)>< 85,000 = —$15,000 va = M 1— 1 7 =—$64,324.57
0.14 1.14 Optimistic Variable Cost, Expected Sales Net Annual Revenue (Sales=85,000, Variable Cost=$2.00) = —$100,000 + ($4.00 — $2.00)>< 85,000 = $70,000 $70,000 1
1_
1.147
NPV if NPV 11
Pessimistic Otimistic NPV $21,441.52 $214,415.24 $192,973.72
Variable Cost $64,324.57 $300,181.34 $364,505.91
= $300,181.34 Page 4 of 12 (b) The project is most sensitive to variable costs because this factor has a higher range
of NPV than sales. (c) Recommend that management pay close attention to variable costs as this could
lead to a project with a negative NPV. This may involve:  more research to better estimate variable costs  conduct a breakeven analysis
 abandon the project because of unacceptable risk Question 4 (a) slope = ﬂ = ——————20% — 75% = 0.833
run 15% (b) For portfolios comprised of the risk free asset and the market portfolio, each
extra percent (1%) of risk will yield an additional return of 0.833%. (c) Zero correlation. Because the risk free asset always returns 7.5% p.a.
irrespective of the return on the market portfolio. Hence the return on the risk free
asset and the market portfolio are uncorrelated. (d) ElRpj = 0.35(.075) + o.s5(.20) = 0.15625 =15.625% cg =.352(02)+.652(.152)+2(.35)(.65)(0)(0)(.15) =0.0095 OP = V0.0095 = 0.0975 = 9.75% Portfolio risk can also be found in the same way as for (e). (e) 12.5% = 7.5% + 0.833(0). ) _12.5%—7.5%
0.833 0,, =6% (f) Yes. By borrowing at the risk free rate and buying the market portfolio. This
strategy leverages the risk (and hence expected return) of the portfolio by
borrowing at a risk free rate and investing the borrowings in a risky asset (the
market portfolio). Page 5 of 12 Mimi (a) The standard deviation (or variance) of possible returns. This risk measure
quantifies the dispersion of realised returns around the expected return. (b) Systematic risk comes from macroeconomic factors, e.g. interest rates,
aggregate demand, political instability, taxation policy etc. Unsystematic is business specific factors, e.g. new competitors, law suit,
management quality, production output, strikes etc. (c) None on systematic risk because all financial assets are under this form of
macroeconomic risk (i.e. it is nondiversifiable risk). Unsystematic risk can be
reduced (i.e. it is diversifiable risk) because it is firm specific and so negative
returns from one asset may well be offset by positive returns from another asset
— correlation between the returns though must be less than one. (d) The beta, parameter quantifies the level of systematic risk of a risky security
relative to the market portfolio and hence the responsiveness of a security’s
expected return to that of the market return. The All Ords Index is often used as
a proxy for the market portfolio. Hence it must have the same beta as the market
portfolio, which is one and represents the market value weighted average
systematic risk for all stocks comprising the market portfolio. Quesﬂnﬁ The available information set for stocks determines the level of market efficiency. lf
stock prices accurately reflect past information (i.e. the trading record of stocks),
then markets are classed as weak form efficient. lf stock prices also instantaneously
adjust to accurately reflect all relevant current information (i.e. announcements
relating to stocks), then markets are classed as semistrong form efficient. Finally, in
the cumulative hierarchy of informational efficiency, if stock prices also accurately
reflect relevant future information (i.e. knowledge about the growth opportunities of
stocks), then markets are classed as strong form efficient. The level of informational efficiency in markets in turn determines the correctness of
stock prices. Only when markets have a complete and relevant information set and
only when they instantaneously adjust stock prices to accurately reflect this
information (i.e. only when markets are strong form efficient) will stocks be priced as
close as possible (allowing for transaction costs) to their true worth (i.e. be priced
correctly at all times). Stocks are theoretically priced at their true worth (or
fundamental value) when their price equates to the present value of cash flows from
existing operations and growth opportunities. Moving back down the cumulative
hierarchy of informational efficiency will lead to stock prices that increasingly depart
from their true worth. ’ PageGof 12 W
(a) As ABC is allequity financed, its cost of capital equals its cost of equity capital: _ do(1+g)
KE — PE +g do = $0.30
$0.30 = $0.12(1 + g)5 g = 0.20 PE (exdividend) = $12.50 — $0.30 = $12.20 _ $0.30(1 +0.20) _ o
KE _ $12.20 + 0.20 _ 0.230 (or 23.0 /o)
1
(b) KE = do(P: g) +g $0.30 = $0.12(1 + g)5 The cost of equity capital (K5) is implied by the equity valuation model that
equates the equilibrium (i.e. assumed to be determined in an efficient market),
exdividend share price to the present value of the equity’s expected dividend
payments to perpetuity. The cost of equity capital reflects the systematic risk of
the expected dividends from holding equity. From their current level, dividends are expected to grow at a constant rate (9) to
perpetuity, in ABC’s case based on the implied dividend growth rate over the
past five years. (c) ABC’s cost of capital (of 23.0%) would be an appropriate discount rate for the
following reasons: > The cost of capital can only be used as the discount rate for evaluating
investment projects when they are marginal projects (i.e. small relative to the
size of their companies) and when their systematic risk is estimated to be the
same as that of their companies. In ABC’s case, each of these conditions is
satisfied. > An appropriate discount rate should reflect the existing and overall financing
arrangements of companies and not specifically those chosen for their
investment projects. The cost of capital is an appropriate discount rate for
this reason. Notwithstanding this, the cost of capital can only strictly be used
as the discount rate when the financing arrangements chosen for investment
projects do not materially change the existing capital structure of their
companies. In ABC’s case, this condition is also satisfied. Retained earnings
form part of the equity capital of companies. As such, retained earnings are
priced in to the shares of companies and in turn in to their costs of equity
capital. Page 7 of 12 Question 8 (a) As XYZ is financed by equity and debt capital, its cost of capital equals its
weighted average cost of capital: VE VD
KA = KE xw+ KD(1—tc)><VA‘
KE=13.2°/o
KD=EIB i=$100><0.10=$10 PD=$1OO><1.10=$11O
$10
= = . . °/o
KD $110 0091(or91 )
tc=0.30
VE=12.5
VD=3 VA=12.5+3 = 15.5 12.5 o 3 0
155+ 9.1 /o(1 —o.30) x 11.9/o _ o
KA—13.2/oX (b) XYZ’s systematic risk (BA) can be estimated from an adapted capital asset pricing
model: E(Ri) == R1+ [E(RM) — R1131
KA = Rf + [E(RM)  Rf]BA
KA = 11.9% from (a) R: = 6% E(RM) = 12% 11.9°/o = 670 + [12°/o  6°/o]BA BA = 0.98 Page 8 of 12 magma) Pix/Ergo r WST
0F CA FKos’ECr AccePrED 5h§wnc¢>
when :1— 5». may 3e 166me) Kevané» BV) Claime
(c) Diagram: AS§€T 1916:0333? MDE‘L (CA/M» 6%) CA Fm F’Ro matr HAQC (K L .
mezﬂh Fem er If the investment project’s rate of return falls between XYZ’s cost of capital (of
11.9%) and the projects minimum required rate of return, found by using the
capital asset pricing model to obtain a discount rate matched to the project’s
systematic risk, then the project will be incorrectly accepted because it will give
the impression of being a positive net present value (NPV) project when in reality
it generates a negative NPV. Because the investment project is 40 percent more risky than XYZ’s existing
operations, by using its cost of capital, reflecting as it does the average
systematic risk of its operations, the company will be applying too low a discount
rate to the project’s cash flows and therefore overstating its NPV. In essence,
XYZ would be violating the condition that the cost of capital can only be used as
a discount for evaluating investment projects when their systematic risk is
estimated to be the same as that of their companies. Page 9 of 12 Question 9 (a) According to perfectmarket theory, shareholders will be able to differentiate
precisely between not receiving dividends because of the poor prospects of their
companies, versus not receiving dividends because their companies are reliant
on retaining distributable cash flow for financing positive net present value (NPV)
investment projects. In the latter case, because shareholders are perfectly
informed about the investment opportunities of their companies (i.e. they have a
complete information set about their companies, which is both understandable
and believable), they will be in a position to accurately revise upwards their
expectations regarding cash flows and hence dividends, and possibly also to
revise downwards their estimation of the riskiness of dividends. The share prices
of their companies will therefore rise, reflecting as they now do the present value
of higher expected dividends. in this way, shareholders will be compensated for
not receiving dividends in a particular year by receiving capital gains instead.
When shareholders have the same information set as their companies they will
not therefore expect dividends when there are positive NPV projects that need
financing through retaining distributable cash flow. If this is indeed the reason
why no dividends are being paid, then the share prices of their companies will
not suffer. On the contrary, the share prices of their companies will rise to
accurately reflect the decision to invest in shareholder wealth increasing projects.
This is Modigliani and Miller’s irrelevancy theory of paying dividends versus not
paying dividends. In complete contrast, realworld arguments recognise that shareholders are not
perfectly informed about the investment opportunities of their companies.
Shareholders will therefore most likely confuse a decision not to pay dividends
because positive NPV investment projects require internal financing, with the
decision not to pay dividends because their companies have poor prospects. In
such an uncertain information world, the decision by companies not to pay
dividends will inevitably cause their share prices to suffer because imperfectly
informed shareholders will more likely than not expect dividends, and when they
are not forthcoming they will be more inclined to revise downwards their dividend
expectations and to revise upwards their estimation of the riskiness of dividends,
so causing share prices to fall. Shareholders will not therefore be compensated
for not receiving dividends in a particular year by receiving capital gains instead.
This is the imperfect information content theory of dividends or the signalling
theory of dividends. The decision not to pay dividends, even when the intentions
of companies are in their investors’ best interests, causes imperfectly informed
shareholders to impute adverse signals about the prospects of their companies
and hence to adversely affect share prices and in turn their wealth. Page 10 of 12 (b) A wholly residual dividend policy is one in which companies at the outset apply
their distributable cash flow to financing positive net present value investment
projects. Only if shareholder wealth increasing investment projects dry up before
all distributable cash flow has been allocated do they then pay out the remainder
as dividends. Dividends from one year to the next are therefore determined by
the availability of investment opportunities for companies and their accessibility
to capital markets for external finance (meaning that they do not have to be so
reliant on internal finance). The resulting pattern of residual dividends will most
likely be highly variable which will increase shareholder uncertainty about the
prospects of their companies. A highly uncertain dividend policy will ultimately
cause the share prices of companies to suffer. A wholly residual dividend policy
would therefore exacerbate the imperfect information content theory of dividends,
or signalling theory of dividends, and in reality would therefore provide support
for the claim. Page11of12 FORMULA SHEET PV=£
l
NPV=—C‘—+ C22+....+ C" —CO
1+k (1+k) (1+k)"
Amww=AmVx—gikl—
a+kY—1
O'M E(Rp) = wiE(Ri) 2 2 2 2 2
Up = W101 +W202 +2W1W2p120102 do(1+g)
K = +
E PE 8
K i
D PD
VE VD
K =K x——+K1—tc x—
A E VA D( ) VA mm=&+wmw—Mﬂ Page12of12 ...
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 Three '08
 Smith
 Finance, Capital Asset Pricing Model, Net Present Value, systematic risk

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