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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 NONALPHABETIC KEYBOARD YES El NO
OPEN BOOK C] YES 52] NO SPECIFICALLY PERMITTED ITEMS [1 YES 3 NO
If yes, items permitted are:   ~ "ER . Was3.1m.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 +2WIW2p20102 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 riskreturn 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 riskreturn 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. marketwide) 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 0166 (1666) KE Cost of debt capital l _$100,000 K” :63“ $800,000 = 0.125 (12.5%) Weighted average cost of capital KA= KEx—gEl 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'? («l1
RmsmenAVx'S:0rx L = 41.2 firI.
Remain.mounciklcI :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—wMs
{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 — taxbased 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 taxbased 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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 Three '08
 Smith
 Finance, Capital Asset Pricing Model, Net Present Value, systematic risk

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