MU - S2 2004 - Business Finance Exam Solutions

MU - S2 2004 - Business Finance Exam Solutions - MONASH...

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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 (in-full) I I I _ g ' Vit!Iinf]Iltoga.lin!l‘ilgjiiwlunIclf'lllltvllllln-lllnil}.-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 =50’597-03 m = $116,967.56 1.123 NPV(Shinymetal) co =38,219-75 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(A|uminia) = $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 non-diversifiable 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 semi-strong 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 all-equity 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 (ex-dividend) = $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), ex-dividend 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’EC-r AccePrE-D 5h§wnc¢> when :1— 5». may 3e 166me) Kevan-é» BV) Claime (c) Diagram: AS§€T 1916:0333? MDE‘L (CA/M» 6%) CA Fm F’Ro mat-r 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 perfect-market 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, real-world 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 +W20-2 +2W1W2p120-10-2 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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This note was uploaded on 08/25/2008 for the course AFF 3111 taught by Professor Smith during the Three '08 term at Monash.

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MU - S2 2004 - Business Finance Exam Solutions - MONASH...

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