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Unformatted text preview: MONA UNIVERSITY LIBRARY i iiiiiiiiiiiiii ii 0041 1 6898
Office Use Onl
Monash University
Semester One 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 PA PER IS FOR STUDENTS STUDYING AT: (tick where applicable)
El Berwick IZI Clayton El Malaysia El Distance Education El Open Learning
El Caulfield El Gippsl(and El Peninsula El 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 IZI YES El NO
OPEN BOOK/NOTES El YES NO
SPECIFICALLY PERMITTED ITEMS El YES IZINO If yes, items permitted are: Camdidéfésfmust ampere toanswer in this paper I I , STUDENT H‘m— ————.——_: ““ —— “ H SURNAME ...... ..: .... .... ...................... ......L...‘;‘STIGNATURE. _
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.2 235,351.,1. M = —Zo_¢/ooq .4, 135,3:LLESL Question 3 (a) Portfolio Return:
E[Rp] = O.2(0.08) + O.5(O.12) + O.3(O.11) = 0.109 (10.9%) Portfolio Variance: 2 _ 2 2 2 2 2 2
0,, — w10'1 + w20'2 + W303 + 2w1w2p120'10'2 + 2w1w3p130'10'3 Since p23 = 0, this term is
ignored a; = (0.2)2(0.07)2 + (0.5)2(0.10)2 + (0.3)2(0.09)2
+ 2(0.2)(0.5)(0.8)(0.07)(0. 10) + 2(0.2)(0.3)(—0.2)(0.07)(0.09) a; = 0.000196 + 0.0025 + 0.000729 + 0.00112  0.000152
0; = 0.004393 0 = 0.06628 (6.6%) Eﬁicient Frontier E
3
‘5
I:
U
0
H
U
0
a.
x
I." (0) Since the portfolio risk and expected return calculated in (a) is below the efficient
frontier, it is inefficient. Consequently, a riskaverse investor will not hold it. (d) Refer to chart. The line joining the riskfree return that is tangent to the efficient
frontier represents the opportunity set now available to the riskaverse investor.
An investor can reduce risk by lending at the riskfree rate, or risk may be
increased by borrowing at this rate. This will enable investors with different risk
preferences to achieve a higher level of utility that would not be possible in the
absence of a riskless asset.  Question 4 (a) CML represents combinations of the riskfree asset and the market portfolio in
expected return and risk space. Only efficient portfolios lie on the CML. Risk is
measured by the standard deviation (i.e. total risk). The SML represents an equilibrium relationship between risk and expected
return. Risk is measures by beta (i.e. market risk). The SML may be used to
price efficient and inefficient assets. (b) E[R] E[R] = .................................................................. .. Rr CA 0']; BA = [33 Portfolio A is efficient because it plots on the CML. Portfolio B is inefficient
because its return is the same as for portfolio A, but the risk is higher. Portfolio B
is not a combination of the riskfree asset and the market portfolio. A rational
investor would not hold portfolio B. The CML can only be used to price efficient
portfolios. Portfolios A and B have the same expected return, hence, in
equilibrium, they must also have the same beta. It is apparent from the above
diagram that this does not carry through to the CML, as the CML concentrates on
standard deviation rather than beta. The extra standard deviation associated with
an inefficient portfolio is called diversifiable or unsystematic risk. Investors are
not compensated for this risk because in equilibrium no investor would hold an
inefficient portfolio. The CAPM, represented in the diagram by the SML, prices
all assets, whether they are efficient or inefficient. (C)
(l) CAPM:
E[Ri] = Rr+ B(E[RM]— Rf)
E[Ri] = 0.06 + 0.7(0.18 — 0.06) = 0.144 (14.4%) The asset return is not consistent with CAPM because the return is higher
than expected. (ii) An investor may benefit by purchasing this asset, since its price is below
the equilibrium price, and short selling an efficient asset with identical risk.
Since the beta for both assets is the same,’ there is no risk. This will result
in an arbitrage profit. (d) The CAPM implies that only systematic risk is important in explaining returns.
Evidence provided by Fama and French (1992) suggests that there are
additional factors, such as firm size and book value over market value. Roll’s (1977) critique “pointed out that the security market line follows purely as a
matter of mathematics from the capital market line. In short, the security
market line will appear to be valid even when it is not.” (Peirson & Bird p. 226) The difficulty with testing the theory is compounded by the problem of identifying
a market portfolio. Since a market portfolio consists of all assets, not just shares,
it is neither possible nor practical to measure the returns on all assets, which
invalidates existing tests using only a share price index to represent the market
portfolio. Question 5 Efficient market theory, in its most extreme sense, proposes that stock prices
instantaneously and correctly adjust to reflect all relevant, randomly received,
information. The information set of even the bestinformed investor will therefore be
the same as that of the stock market. As such, investors cannot earn returns, on
average, in excess of the expected return for the level of systematic risk to which
they are exposed. Not being able to ‘beat the market’ gives rise to the popular
misconception that investors will be no worse off by simply randomly selecting stocks
for inclusion in their portfolios. It should be stressed to the misinformed investor that efficient market theory in no
way diminishes the importance of portfolio theory, i.e. the importance of non
randomly selecting stocks for portfolio inclusion is undiminished by the implication of
not being able to earn abnormal returns. Portfolio theory implies that investors
should carefully select stocks not to ‘beat the market’, but rather in order to achieve a
level of diversification that suits their systematic risk preferences. This could only be
achieved by chance if investors were simply to randomly select stocks. Question 6 (a) (0 Share price = 28 x 35.8 cents = 1002.4 cents [i.e. P/E ratio = Share Price + EPS]
Dividend growth rate, 9 = (11 + 4.86)“4 — 1 = 22.7% [i.e. 11 = 4.86(1 + g)4] 11(1+ 0.227) _ 0
1002.4 + 0.227 — 24/0 Cost of equity capital = (ii)
Cost of equity capital = 10% + 0.8[19% — 10%] = 17.2% (b) ONE of the following: It is assumed that the estimated dividend annual growth rate (i.e. 22.7%) will
continue indefinitely. lf future dividends do not turn out to grow at a constant
rate, ad infinitum, based on past dividends, the cost of equity capital will be
computed based on discounting incorrectly estimated future dividends so that
they equate to the current share price. Assuming the share price is correct, if
future dividends grow at a lesser rate than past dividends, the cost of equity
capital will therefore be overstated, and vice versa, if future dividends grow at a
greater rate than past dividends. It is assumed that the share price used (i.e. 1002.4 cents) is in equilibrium. If the
company’s share price is currently mispriced because the stock market has
incomplete information about the company’s true worth, the cost of equity capital
will be estimated based on discounting future expected dividends so that they
equate to an incorrect current share price. Assuming future dividends have been
estimated correctly, if the share price is currently undervalued, the cost of equity
capital will therefore be overstated, and vice versa, if the share price is currently
overvalued. it is assumed that the share price used is exdividend (i.e. the current share price
is the share price just after the annual dividend has been paid). If this is not the
case, the cost of equity capital will be estimated based on discounting future
expected dividends so that they equate to a share price that is too high because
it incorporates the value of the current dividend. Assuming future dividends have
been estimated correctly, the cost of capital will therefore be understated. Equity holders make capital available to companies for a required return, in what
is to them a financial investment. Mangers of companies put the equity capital to
use by investing it in real projects for a prescribed, opportunity cost. The
managers’ opportunity cost of using equity capital to invest in real projects
equates to the equity holders’ required return. This is because the managers
must earn at least the equity holders’ required return from investing in real
projects, as they (i.e. the equity holders) have effectively forgone an equivalent,
bestavailable return for the same level of systematic risk to which they will
alternatively be exposed to through their companies’ real investment projects. Under certain conditions, the cost of equity capital can therefore provide
managers With the correct discount rate for real investment projects because it is an opportunity cost reflecting the systematic risk of the suppliers of equity
ﬁnance. Question 7 $4m(1+ 0.06) a C t f 't ' =
( ) cs 0 equlycapltal $303!“ + 0.06 = 20% Cost of debt capital =§$§6 = 10% [Le 1': 0.08 x $100] $30.3m + 100/ X $10.1m
$40.4m ° $40.4m WACC = 20% x = 17.5% [i.e. VD = $80($12.625m + $100) and VA = $30.3m + $10.1 m] (b) Riskmatched expected rate of return for lower risk division
= 8% + O.8(15% — 8%) = 13.6% Riskmatched expected rate of return for higher risk division
= 8% + 1.92(15% — 8%) = 21.4% Expected rate of return for overall company = WACC = 17.5%, reflecting
company’s average systematic risk level = 0.5 x 0.8 + 0.5 x 1.92 = 1.36 (where 0.5 weights reflect the fact that company’s business is roughly divided equally
between its two divisions). As the company is diversified (i.e. it operates in more than one industry) and its
divisions have very different systematic risk levels from one another, using the
WACC to evaluate investment opportunities across its entire business is likely to
result in some incorrect (i.e. shareholder wealth decreasing) investment
decisions being made. Specifically, for the lower risk division, using the WACC as a discount rate will
mean that too high a discount rate (i.e. 17.5% versus 13.6%) will be applied to
this division’s investment opportunities, because the WACC reflects too high a
systematic risk level (i.e. 1.36 versus 0.8). As a result, investment opportunities
in this division returning between 13.6% and 17.5% (i.e. using the appropriate
discount rate of 13.6%) will be incorrectly rejected using the WACC as the
discount rate. For the higher risk division, using the WACC as a discount rate will mean that too
low a discount rate (i.e. 17.5% versus 21.4%) will be applied to this division’s
investment opportunities, because the WACC reflects too low a systematic risk
level (i.e. 1.36 versus 1.92). As a result, investment opportunities in this division returning between 17.5% and 21.4% (i.e. using the appropriate discount rate of l
21.4%) will be incorrectly accepted using the WACC as the discount rate. The WACC is therefore inappropriate as a discount for diversified companies
because it represents the expected return for the overall company, thus reflecting 1
the average systematic risk across its divisions. The capital asset pricing model (Cﬁi’m) will provide an appropriate, riskmatched discount rate for each division, I
accounting as it does for the specific systematic risk level of each division. l
Diagram 8} A .jTi' u <2"
211%“ ?m ‘
IE
$4 08 3g Question 8 (a) In formulating a dividend policy for their companies, managers need to decide
how the annual distributable cash flow (i.e. after tax and interest) will be split
between dividend payments and retention for future investment. Distributable
cash flow retained for investment will (in theory at' least) lead the stock market to
revise upwards its expectations as to the future level and/or systematic riskiness
of dividends, so generating a capital gain for equity holders. In effect, therefore,
in formulating a dividend policy, managers are deciding how to package the
annual return to equity holders. f managers decide to retain a low proportion of
distributable cash flow, the equity holder return will mostly be expected in the
form of cash dividends. If, on the other hand, managers decide to retain a high
proportion of distributable cash flow, the equity holder return will mostly be
expected in the form of capital gains. (b) The two main theoretical justifications for maintaining a consistent dividend policy
are the clientele and imperfect information content of dividends (or signalling)
arguments. Clientele argument In the real world, the wealth of equity holders is affected by their degree of
exposure to transaction costs (of one kind or another) and capital gains tax.
These market imperfections make it costly for equity holders to adjust the
dividend pattern of their companies in order to suit their own consumption
preferences. Hence, if companies maintain a consistent dividend policy they will
attract and maintain a unique group of equity holders who have income needs
satisfied by their respective dividend policies. Equity holders are therefore able
to minimise their exposure to transaction costs and capital gains tax. By maintaining a consistent dividend policy, companies will simultaneously
attract and maintain a unique group of equity holders who are in a tax class most
efficiently suited to their respective dividend policies. In the presence of an
imputation taxation system, equity holders with marginal personal tax rates less
than or equal to the company tax rate will be attracted to companies paying out
the maximum amount of fully franked dividends. This is because low tax paying
equity holders will be able to take full advantage of the imputation credit attached
to the dividends, and so be able to maximise their aftertax returns. On the other
hand, high tax paying equity holders (who are left with some personal tax to pay
after using the imputation credit) might be able to maximise their annual returns
by instead investing in companies paying low dividends. This is because they
will now partially be subjected to a more favourable (i.e. relative to their marginal
personal tax rate) capital gains tax rate. Signalling argument In the real world, managers are generally better informed than equity holders
about the future prospects and, hence, true worth of their companies. By
maintaining a consistent dividend policy, managers are able to reduce the
uncertainty that would inevitably be induced by an unstable dividend policy. The increased systematic risk associated with a highly variable dividend policy will
arise because equity holders are forced to rely upon imperfect information
indicators of the future prospects of their companies. In an imperfect information
setting, the signals conveyed by the dividend decisions of companies can have
an adverse affect on their market values and, hence, on the wealth of equity
holders. While managers may know that an announcement to significantly
increase the annual dividend belies profitable future investment opportunities,
such a decision may confuse or mislead imperfectly informed equity holders in to
imputing that the company does not, in fact, have any worth while investment
opportunities. Hence, equity holders will revise their systematic risk estimates for
the company upwards, so leading to a fall in the share price. Similarly, while
managers may know that an announcement to significantly decrease the annual
dividend belies profitable future investment opportunities, such a decision may
confuse or mislead imperfectly informed equity holders in to thinking that the
company’s future prospects are poor. Once again, equity holders will revise their
systematic risk estimates for the company upwards and the share price will fall. NPV: i+ C2 1+k (1+k)2 +....+ E[RP] = wiE[R,.]
i=1 n n
12’: Z ZwiwjpijOiOj i=1 j=1 FORMULA SHEET C n Co
(1+k)” n n n
2 2 2 . .
P: E in'l. +2 2 wiwijO'iaj (1qu)
i=1 i=1 j=1 GP = H
E(Ri) = Rf+ ﬁi[E(RM)  Rf] ﬂ __ UiM _ piMGiGM
i——_———— a"; a";
d
E: o(1+g)+
PE
K __i_
D—PD
VE VD
KA=KEX—+ DX—"'
A VA Page 7 of 7 ...
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