MU - S2 2003 - Business Finance Exam Solutions

MU - S2 2003 - Business Finance Exam Solutions - TY LIBRARY...

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Unformatted text preview: TY LIBRARY 50 w m s I iiiiiiiii i iiiiiiiii 004110198 Office Use Onl Monash University Semester Two Examinations 2003 Faculty of Business and Economics EXAM CODES: AFC2140 TITLE OF PAPER: BUSINESS FINANCE EXAM DURATION: 180 minutes writing time READING TIIIIIE 10 minutes THIS PAPER IS FOR STUDENTS STUDYING AT: (tick where apprcabfe) El Berwick Clayton El Malaysia El Distance Education El Open Learning El Cauifield El Gippsland El Peninsula [II Enhancement Studies El Other (specify) INSTRUCTIONS TO CANDIDATES: This paper contains 8 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. Candidates are reminded that they should have no material on their desks unless their use has been specifically permitted by the following instructions: AUTHORISED MATERIALS CALCULATOR WITH NON-ALPHABETIC KEYBOARD YES El NO OPEN BOOK C] YES 52] NO SPECIFICALLY PERMITTED ITEMS [1 YES 3 NO If yes, items permitted are: - -- ~ "ER . Was-3.1m.a}; Page 1 of 1 QUESTION 1 (a) Present value terms — if investors swap an amount of their current wealth (equal to the required outlay) for the future expected cash flows then the wealth of investors (as a group) will increase by $100.000. Future value terms — investment opportunity is expected to produce cash flows sufficient for investors to recover the wealth initially sacrificed and to generate a rate of return in excess of the 10% rate of return required by investors. (b) incremental cash flows — opportunity costs Cash inflows from not undertaking an investment that will be forgone by undertaking the investment. ' These forgone cash inflows will change to become cash outflows. and these cash outflows will occur only as a result of undertaking the investment. Examples might include: Retaining some plant and machinery for an investment project that will otherwise be sold to generate a cash inflow if the project is not undertaken. Lost operating cash inflows from one part of a company because of financial constraints and the need for additional manpower to undertake an investment project. Lost cash inflows if a manufacturing plant previously leased out to another company is now needed to undertake an investment project. QUESTION 2 EAV 1 ' 250000=—~— Ir (a) m ’ 0 9[ 1.123] 250,000 = EA V(4.9676) EAV = 50,325.11pa (ii) EAV is the annual payment of an ordinary annuity which has the same economic life and NPV as the proposed project. (iii) If the discount rate decreases the net present value of the project will increase and so will EAV. Page 2 of 2 (b) (i) (0.4). “High”. $200,000 pa for 3 years Proceed (-$400,000) (0.6). “Loni”. $100,000 pa for 3 years Don’t proceed .. 200 000 1 100 000 1 n Ex ected a off: 0.4x ’ 1— +0.6 ’ 1— H p p y [ 0.1 £ 1.13] x 0.1 £ 1.13)] = 0.4*497.370.40+0.6*248.685.20 = 348,159.28 Net present value = -4.00,000+348,159.28 = 61,840.72 The project should not proceed. QUESTION 3 (a) (i) independent projects — the decision to acceptlreject a project has no effect on the decision to acceptireject any other project. Mutuaiiy exclusive projects — the extreme of dependence in that both projects cannot be accepted at the same time. (ii) Select B because it has the largest NPV and therefore maximises shareholder wealth. (iii) Because of differences in the timing andfor magnitude of cashfiows, interrelated with the fact that the RR method results in a rate of return (not an absolute amount of change in wealth) and (unlike the NPV method) does not use the required rate of retum in the discounting process. Page 3 of 3 (b) (i) The time value of cashflows is not incorporated into the analysis. The method is biased against projects with large cashflows late in the life of the project. i.e. ignores cash flows after the payback period. The method does not result in a measure of shareholder wealth. (ii) Arbitrary: the choice of depreciation schedule, inventory valuation, etc. will significantly affect accounting profit estimates, i.e. does not focus on cashflows. The timing and time value of money is not taken into account in its calculation. QUESTION 4 (a) (i) E(R) = 0.35(o.1) + 0.65(0.15) = 0.1325 (or 13.25%) (ii) 02 = (.35)2(0.12)2 + (.65)2(0.18)2 + 2(.35)(.65)(0.12)(O.18)(0.7) = 0.02179 (7 = 0.1476 (or 14.76%) (iii) The portfolio risk would increase. (b) (i) No benefits. (ii) a": = WIZO'IZ +142§U22 +2WIW2p|20102 if perfectly correlated then pl2 =1 , so 2 _ 2 2 2 2 0p — wits?I +1920"2 +2wiwzc71o2 = (W; a, +1456?)2 80 portfolio risk is the weighted average of risk levels of the component assets. (c) The total risk of a portfolio is measured by the standard deviation of its returns. The total risk of a portfolio can be reduced by increasing the number of assets in the portfolio, provided that the asset returns are not perfectly (positively) correlated. The systematic risk of an asset is measured by its beta value. This is the relevant measure of an asset's risk for an investor who holds the asset as part of an efficient portfolio. Systematic risk is that component of an asset’s total risk that cannot be diversified away and it is totally dependent upon market factors. Unsystematic risk is the difference between an asset's total risk and its systematic risk and is that part of total risk that is specific to the asset. Unsystematic risk is sometimes referred to as the asset's diversifiable risk as it can be completely removed by holding the asset as part of an efficient portfolio. Page 4 of 4 QUESTION 5 (a) (i) A curve representing the risk-return relationship for all portfolios that maximise the return for a given level of risk, or minimise the risk for a given expected return. (ii) A theoretical portfolio comprising all potential assets in the market weighted by the assets’ values. (iii) This line represents the risk-return relationship for all efficient portfolios, is. those comprised of the market portfolio and a risk free asset. (iv) This line shows the return an investor can expect from investing in an individual (and hence inefficientfrisky) asset. given the risk free rate of return, the expected return from holding the market portfolio, and the asset's own level of systematic risk. (b) The )6 parameter in the CAPM tells potential investors the systematic (i.e. market-wide) risk of individual securities (i.e. financial assets that are risky in an unsystematiclfirm- specific sense) relative to the base case of the market portfolio (Le. with all unsystematic risk diversified away). it can be estimated by performing an ordinary least squared regression of market retums on individual security returns. QUESTION 6 (a) (10) Fair game — investing in stocks will, on average, earn investors a return equal to the expected retum (i.e. they can expect to be compensated for the degree of their systematic risk exposure — no more or less). Efficient market theory - stocks are a fair investment Stock prices instantaneously adjust to accurately reflect all relevant randomly received information. Stocks are therefore correctly priced at all times and investors always have the same information set as the market. Professional, disbelieving investors — arbitrageurs. Role in context of stock market efficiency Arbitrageurs look for opportunities to profit from mispriced stocks resulting from an inforrnationally inefficient market. Strong competition among arbitrageurs serves to speedin bring the missing information in to the public domain, and in the process reinforces market efficiency. Page 5 of 5 QUESTION 7 (a) Marginal investmen — if the appropriate discount rate is the weighted average cost of (b) (C) (d) capital then an implicit assumption is that the new investment opportunity should be small relative to ABC Company’s existing assetsloperations. Oggortunity cost — discount rate should represent the minimum acceptable return that ABC Company's investors could have earned elsewhere for hearing the same level of systematic risk as that of the new investment. Recommendation 1 — general error Discount rate should reflect the overall cost of ABC Company’s existing capital structure — NOT the specific cost of the type of capital intended to finance the new investment opportunity. Recommendation 2 — precise errors Cost of equity capital should be estimated using future expected (NOT past) dividend growth. Cost of debt capital should be estimated using the market (NOT balance sheet) value of debt. Weighted average cost of capital should be estimated by applying corresponding market (NOT balance sheet) value weights to the costs of equity and debt capital. Cost of eguity capital _ Do(1+ g) + g _ $1,000.000(1+ 0.06) = 0 VE $10,000,000 +006 0-166 (16-66) KE Cost of debt capital l _$100,000 K” :63“ $800,000 = 0.125 (12.5%) Weighted average cost of capital KA= KEx—gE-l- Kg x¥= 16.6% x $1 0,000,000 $1 0.800.000 $800,000 0 _...._...— + 12'5 A” X $10,800,000 = 16.3% Single discount rate — ABC Company’s existing operations are highly focused. Risk Question — does the new investment opportunity have the same degree'of systematic risk as that of ABC Company’s existing and overall assetsloperatlons? Page 6 of 6 (3) Using discount rate estimated from misinformed recommendations How will evaluation be adversely affected? New investment opportunity will be incorrectly accepted (la. the net present value will be deceptively greater than zero) if it earns a rate of return between the answer to (c) and - the estimated discount rate based on either of the misinformed recommendations. Why will evaluation be adversely affected? Discount rate based on either of the misinformed recommendations reflects too low a systematic risk level, and therefore too low a discount rate (minimum required rate of return) will be imposed on the new investment opportunity. .S’mL Ce f'ful": 5t is'cwnL'? («l-1 RmsmenAVx'S:0r-x L = 41.2 fir-I. Remain-.mounciklc-I :2 r1 CL E(VYQM: rm MCLr- kmb'rt'n == :10 -/. fry—157d pm...” strung fimg‘? ' dfizhmtnamk‘;0ni (f) Proof that ABC Com an ’s existin and overall riskiness is less than overseas investment opportunity E(r) of ABC Company’s existing and overall assets = 16.3% = rf + [E(rm) — rng fABCC ’ ‘t‘ ndo ll ts—w-Ms {30 ompanys exrs Inga vera asse — 15%_5% . 1.13<1.50 Theoretically correct discount —- should be estimated using the capital asset pricing model. Rationale ~— produoes a discount rate matched to the systematic risk level of the overseas investment opportunity. Page 7 of 7 QUESTION 8 (a) “More than 80 per cent responded by agreeing that there are negative consequences to reducing dividends, and that dividend decisions convey information about their company to investors." Recognisable theoLy — imperfect information content of dividends! signalling theory. Explanation Shareholders are unlikely to be perfectly informed as to the circumstances (good or bad) giving rise to the decision to reduce dividends. Signalling theory suggests that shareholders will most likely impute bad information from the decision to reduce dividends because when there is incomplete information dividends are a key. costless indicator of the company’s current state and future prospects. Potentially imperfect information content of reduced dividends will most likely cause shareholders to revise upwards the company’s systematic risk level, so causing its share price to fall and adversely affecting their wealth. “Just over 20 per cent responded by agreeing that the personal taxes their shareholders pay when receiving dividends is an important factor in determining their company’s dividend policy." Recognisable theory — tax-based clientele theory. Explanation Shareholders can be grouped according to their different tax classes for dividends and capital gains. Composition of a company’s shareholder base (i.e. the shareholder clientele a company will attract) is partially determined by how much personal tax shareholders will pay on the company‘s level of dividends relative to retaining cash in the company and instead receiving a capital gain. In Australia, shareholders with personal tax rates less than (or equal to) the corporate rate will derive the most value (i.e. have the lowest personal tax costs) from using imputation credits. and because of this they will be attracted to company’s paying out the maximum amount of fully franked dividends. Relative importance of theories in practice — strong support for the signalling theory. but very weak support for the tax-based clientele theory. [Note: very weak support for the signalling theory most likely reflects the fact that the US, unlike Australia, does not have a full imputation taxation system]. (b) Factors determining consistently high or low dividend policy _ Future (positive net present value) investment funding requirements interrelated with accessibility to capital markets for external finance. Page 8 of 8 ...
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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 2003 - Business Finance Exam Solutions - TY LIBRARY...

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