Question 1

10. Huawei Corporation is considering the opening of its state-of-the-art research laboratory. The project will involve an investment of $78 000 000 and will produce a positive cash flow of $25 000 000 in the first year. The cash flows will increase by 10.00 per cent each year thereafter for another five years (i.e. the project runs for six years in total). At that stage the project will Huawei expects a rate of return of 17.00 per cent on this project.

1. Calculate the NPV of the project.

1. Should the company proceed with this investment opportunity? Why or why not?

1. The required rate of return of Rio Tinto Ltd and BHP Ltd is less than 15 per cent per

• The current earnings per share of Rio Tinto Ltd are $1.50 and the company does not reinvest any of its earnings. Calculate the current share price of Rio Tinto

• BHP Ltds current dividend per share is 80 cents and it is expected to grow at 5 per cent per annum. Calculate BHP Ltds current share

SOLUTION GUIDE

• To find the NPV, find the PV of each of the cash flows, add them up and subtract the $78 000 000 investment.

r = 0.17

NPV =

t =1

Ct

(1+r)t

• C0

Year	Net Cash Flows
0	-$78 000 000
1	$25 000 000
2	$27 500 000
3	$30 250 000
4	$33 275 000
5	$36 602 500
6	$40 262 750

Correct calculation of net cash flows Sum (PV) = 110 491 841

NPV = Sum (PV) C0 = 110 491 841 - $78 000 000 = $32 491 841.

• The project has a positive NPV, therefore the company should proceed with

the project. Shareholders wealth will increase by the NPV = $32 491 841

1. The required rate of return of Rio Tinto Ltd and BHP Ltd is less than 15 per cent per

• The current earnings per share of Rio Tinto Ltd are $1.50 and the company does not reinvest any of its earnings. Calculate the current share price of Rio Tinto Ltd.

• BHP Ltds current dividend per share is 80 cents and it is expected to grow at 5 per cent per Calculate BHP Ltds current share price.

(i) P0 = D ke = $1.50 0.15 = $10.00 (ii) P0 = = $0.80 0.15 = $8.40

(1.05)

- 0.05

Question 2

1. Linda Plant Hire Ltd has signed a loan contract to purchase a new The interest rate is 8% and the annuity consists of six cash payments of $6000 payable annually. Calculate the value of the annuity today if the first cash flow is to be paid:
   1. in one year
   2. in four years

1. An investor holds the following shares in an investment portfolio:

JB Hi-FI	$6 500	Beta 1.2
Telstra	$8 600	Beta 0.95
ANZ Bank	$7 900	Beta 1.05

1. What does each beta coefficient imply about the volatility of each companys shares relative to the overall market?

1. Calculate the weighted average beta of the

SOLUTION (a)

• This is an ordinary

C 1

n

P = 1-

i (1+i)

$6000 1

P =

0.08

1-

6

(1.08)

P = $27737.28

• This is a deferred annuity:

1 C 1

( )

P = k -1

1+ i

1-

n

i (1+i)

Recall that n is the number of cash flows and k is the number of time periods until the first cash flow. Hence, n = 6 and k = 4. Therefore:

1 $6000 1

3

P =

(1.08)

0.08

1-

6

(1.08)

P = (0.793832)*( $27737.28) = $22018.75

SOLUTION (b)

1. Beta is the amount of systematic risk that is present in a particular share relative to the share market as a whole.

The market has a beta of 1.0.

In the above portfolio, JB Hi Fi and ANZ have betas greater than 1.00. As such, they are more volatile than the market. When the S&P/ASX 200 increases (decreases) by 10 per cent, JB Hi Fis price will increase (decrease) by 12 per cent or 1.20 times as much. Following the same market movement, ANZ shares will increase (decrease) in price by 1.05 times as much or, in this case, by 10.50 per cent. Because Telstra has a beta of 0.95, it will move less than proportionally with the market.

• The weighted average beta of the portfolio is:

	Amount	Portfolio Weight	Beta	Weighted Beta
JB	6500	0.282609 (=6500/23000)	1.20	0.3391 (=1.20 x0.282609)
Telstra	8600	0.373913 (=8600/23000)	0.95	0.3552 (=0.95 x0.373913)
ANZ	7900	0.343478 (=7900/23000)	1.05	0.3606 (=1.05 x0.343478)
Total	$23 000
Weighted Av. Beta	1.0549

1. Yin Zhang bought an investment property last year for $350,000. This year the value of the property has gone up to $400,000. Yin Zhang also received $12,000 in rental income for the year. What is Yin Zhangs holding-period return on the investment?

1. You have invested in Huawei Ltd whose dividend per share has grown 10% per annum for the past 10 Assume that Huaweis growth rate is expected to be maintained indefinitely. The latest dividend per share was 90 cents was yesterday. If your required rate of return is 15 per cent, what is the value of Huaweis shares?

1. The Treasury bond rate is 3%, the average return on the All Ords Index is 12%, and ANZ has a beta of 1.2. According to the CAPM, what should be the required rate of return on ANZ shares?

Answer A: Rt = 400,000 + 12,000 -1

350,000

= 17.71%

Answer B: P0 = D0(1+g)/(ke -g)

= $0.90 (1 + 0.1)/(0.15 0.10)

= $19.80

Answer: C

Substituting Rf = 3%; Rm= 11%; bj= 1.2

Rj = Rf + bj ( Rm Rf )

= 3 + 1.2 x (12 3 )

= 13.8%

According to the CAPM, ANZ shares should be priced to give a 13.8% return

		CASH FLOW ($)
Project	Year 0	Year 1	Year 2
A	$50 000	$10 000	$58 000
B	$50 000	$52 000
C	$50 000	$58 000

The proposed investment projects in the table are independent. The required rate of return of each project is 10%. Which project would you recommend to the firm to accept? Explain your answer, showing all working steps and logical evaluation of the three projects.

SOLUTION GUIDE

Project A:

NPV =

-$50 000 +$10 000 +$58 000

1.1 (1.1)²

= -$50 000 + $9090.91 + $47 933.88

= $7024.79

Proposal B:

NPV = -$50 000 +

$52 000

1.1

= -$50 000 + $42 975.21

= -$7024

Proposal C:

NPV = -$50 000 +

$58 000

1.1

= -$50 000 + $43 636

= -$2066.21

Accept Proposal A, NPV > 0

Proposal A will increase shareholders wealth by $7024.79. By contrast proposals B and C would decrease shareholders value by $7024 and $2066.21, respectively.

1. Benjamin is considering a project which will generate cash flows of $150,000 per year for the next 8 years and have an initial cash outlay of $500,000. What is the projects payback period? Show all working steps.

Year	Outflow ($)	Inflow ($)	Payback
0	500		-500
1		150	-350
2		150	-200
3		150	-50
4		150	100

PHJ Ltd company is considering purchasing a new tunnelling equipment costing $125 000 that will enable it to reduce its existing labour costs by $20 000 a year for 12 years. The company estimates that it will have to spend $3000 every two years overhauling the equipment. The required rate of return is 10% per annum. Assume all cash flows are made at the end of the year, would advise PHJ Ltd to purchase the equipment? Show all the working steps of your answer.

SOLUTION

1 - 1

Savings: $20 000

(1.10)¹²

= $136 274

less Expenditure:

0.10

Initial outlay $125 000

Overhaul after 2 years $3000/(1.10)2 $2479 Overhaul after 4 years $3000/(1.10)4 $2049 Overhaul after 6 years $3000/(1.10)6 $1693 Overhaul after 8 years $3000/(1.10)8 $1400 Overhaul after 10 years $3000/(1.10)10 $1157 Net present value $2496

Decision: As the net present value is positive, the equipment should be purchased.

You are considering investing in a portfolio (Portfolio P), consisting of two shares ABC Ltd and XYZ Ltd. You plan to invest 60% of your funds in ABC and 40% in XYZ. The return on each share over the next year depends on the state of the economy, which could be Boom, Average or Recession. The probability of each state of the economy is shown in the following table, along with the return on each share given that state of the economy. The standard deviations for ABC and XYZ have been calculated for you and are also shown below, as is the beta for each of the shares.

Economy	Probability	ABC Return	XYZ Return
Boom	20%	14%	2%
Average	70%	8%	5%
Recession	?	-3%	12%
Standard Deviation		4.39%	2.59%
Beta		1.6	1.1

The correlation between the two shares is -0.4. The risk-free rate of return is 5%, and the expected return on the market is 9%.

• What is probability of a recession?

100% - 20% - 70% = 10%

• What is the expected return on ABC and XYZ over the next year?

E [R ABC ]= R1 Pr (R1 )+ R2 Pr (R2 )+ R3 Pr (R3 )

=(0.14)(0.2) +(0.08)(0.7) +(-0.03)(0.1) =8.10%

E [R XYZ ]= (0.02)(0.2)+ (0.05)(0.7)+ (0.12)(0.1)= 5.10%

• What is the expected return on the portfolio?

E [R P ]= w1E [R 1 ]+ w2E [R 1 ]

=(0.6)(0.081) +(0.4)(0.051) =6.90%

• What is the beta of the portfolio?

_P=w₁₁+w₂₂=(0.6)(1.6) +(0.4)(1.1) =1.4

• What is the expected return on the portfolio, according to the CAPM?

E [RP]= rf + P(E [RMkt]- rf)= 0.05 + 1.4 (0.09 - 0.05)= 10.6%

• Draw a diagram of the Security Market Line, showing the risk-free asset, the market portfolio, where Portfolio P plots based on your answer to part (c) and where it should plot based on the CAPM prediction given in your answer to part (e).

E(R)

• Based on this diagram, would you conclude that the portfolio is currently overpriced, underpriced or correctly priced? Why?

Overpriced because it plots below the SML. (0.5+0.5)

1. Financial institutions of incorporate loan covenants into loan How does positive covenant differ from a negative loan covenant? Explain your answer.

1. Pure Play approach to estimating the cost of capital poses some List two conceptual and two practical problems that may encountered.

SOLUTION

Part A

• Protective loan covenants are classified as either positive covenants or negative
• A positive covenant states actions that a company must comply with, such as maintaining a minimum level of working capital, or the provision of audited financial statements to the lender within a certain timeframe.
• A negative loan covenant limits or restricts the business activities or financial structure of the company. For example, there may be a limitation placed on the amount of a dividend that can be paid to shareholders, or a requirement that the bank must approve further long- term borrowings of the

SOLUTION

Part B

• Conceptual problems:
  • adjusting equity betas for financial
  • appropriate leverage adjustment depend on the companys capital structure

• Practical problems:
  • Pure play companies are
  • Ignores valuable information from diversified
  • It is possible to estimate divisions cost of capital from diversified company

1. Discuss two factors that influence the yield at which a commercial bill will be What effect does a bank-accepted bill have on the yield?
2. Distinguish between a debenture and a preference

1. ABC Ltd has reached the limit of its debt-to-equity ratio, as stipulated by a negative covenant in its loan contract. If ABC Ltd issues preference shares, would it violate the covenant? Explain your answer in detail.

1. Explain why corporations seek to raise debt funds direct from the markets and why investors provide debt funds directly to the capital

SOLUTION (a)

The yield will be affected by factors that determine the general level of interest rates in the economy, and then by the credit rating of the parties involved.

A bank-accepted bill will include the higher credit standing of the acceptor and so be able to be discounted at a lower yield than a bill issued by a drawer of lower credit standing.

SOLUTION (b)

A debenture is a type of security issued by borrowers. It stipulates regular interest payment and the face value of the security at maturity.

A preference share is a hybrid security that pays a fixed dividend and offers the right to convert to ordinary shares.

SOLUTION (c)

Issuing a preference share would not violate the covenant, because the preference share is a quasi-equity instrument, and would lower the debt to equity ratio.

SOLUTION (d)

• Direct finance occurs when a borrower issues a financial security into the debt markets in order to raise
• The corporate bond markets include the issue of debentures, unsecured notes and subordinated debt.
• Debenturea corporate bond issued with a fixed or floating charge over the assets of the issuer.
• Unsecured notea corporate bond issued without any form of underlying security
• Includes both domestic and international capital

Why do corporations seek to raise debt funds direct from the markets?

• If a corporation can borrow without the need to use a bank, then it is able to save the cost of the banks profit
• Another important reason that a corporation will borrow direct from the markets is to diversify its funding
• If a corporation obtains debt funds from a number of different sources, then it is able to choose the most cost-effective

Why do investors provide debt funds directly to the market?

• By lending direct, an investor is accepting the credit risk associated with the ultimate borrower and should receive a higher return for the higher
• Investors will endeavour to measure the credit risk of a particular debt
• One international standard used as a measure of the credit worthiness of a borrower is a credit rating.
• A credit rating is the rating agencys view of the credit worthiness of a debt