FINA2006 Principles of Finance – T2 2016

FINA2006 Principles of Finance – T2 2016
Group Assignment
Mark Allocation
Question 1 20 marks
Question 2 20 marks
Question 3 20 marks
Question 4 20 marks
Question 5 20 marks
Total 100 marks
Question 1 (20 marks)
Assuming you are applying for a finance job that requires a Bachelor of Commerce degree and your potential employer asks you to respond to two scenarios below.
Scenario 1
Assuming you had $30 000 ‘spare cash’ at the beginning of 1976 and could have used this money to buy a block of land for investment, or to invest in a savings account. The savings account paid interest at 6% per annum, compounded quarterly, and was an ‘at-call’ account, i.e. you could withdraw money at your discretion at any time. At the end of 2015, you were approached by a real estate agent in your local suburb, who was interested in listing the land on behalf of his agency and thus valued the land at an approximate price of $500 000 without charging you a valuation fee.

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Evaluate the above two investment options based on the following criteria and determine which option would have been better at the beginning of 1976 based on these criteria. Note: You are expected to justify and show full calculations for each criterion.
a) The value of each investment at the end of 2015, i.e. land and savings account.
b) The rate of growth in the land value over the period 1976-2015, expressed as a nominal interest rate. Note: The interest was compounded quarterly.
c) The rate of growth in the land value over the period 1976-2015, expressed as an effective interest rate. Note: The interest was compounded quarterly.
d) The amount of cash that would have been invested in the savings account at the beginning of 1976 to accumulate the same value as the land value estimated by the real estate agent at the end of 2015.

Scenario 2
You purchased a 10-year debenture issued by ABC Ltd at the beginning of 2010, which pays a coupon interest rate of 10% per annum and has a face value of $2 000. The coupon payments are made every six months in arrears. Assume it is now at the end of 2016, i.e. exactly 7 years later. Other debentures with similar risk to those issued by ABC Ltd are currently traded in the market at a premium of 2% to the rate of long-term government bonds. In 2016, the long-term government bonds are issued at a market rate of 6% per annum.

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Determine the market value of ABC Ltd’s debenture as at the end of 2016. Question 2 (20 marks)
Assume that you are a registered financial adviser. A potential customer, who holds a well-diversified investment portfolio, is seeking financial advice from you to invest in any or all of the following companies. All of these companies are included in the Australian Stock Exchange’s ASX 300 Index.
Company Beta Expected Rate of Return
Company Alpha 1.6 12.0%
Company Beta 1.2 12.0%
Company Gamma 2.4 13.0%
You have also gathered the following information:
• The expected return on the Australian Stock Exchange’s ASX 300 Index is approximately 9.5% over the coming year.
• The average rate of return on the ASX 300 Index has been higher than that of risk-free Australian securities by around 3.5%.
a) Determine the minimum rate of return for each of the above companies, which would be required by potential investors to invest in each company.
b) Explain whether you would recommend the customer invest in any or all of the above companies. Assume the customer only has an introductory understanding of finance principles and theory. Note: You are expected to justify your advice using common language and understandable terminology.

c) Assume the customer decides to invest $180 000 in a portfolio comprising the above
companies as below:
• Company Alpha $90 000
• Company Beta $63 000
• Company Gamma $27 000
Determine: i) the required rate of return, and ii) beta, for the customer’s portfolio.
d) The customer has also invested in Teta Ltd that has paid annual dividends in past years. The company’s dividends grow at 7% per annum, which is same as Teta’s earnings growth level and is expected to continue indefinitely. Teta’s shares are currently trading at a price of $12.30 each. The customer requires a minimum rate of return of 15% to keep her investment in the company.

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Unit 6 Research project
Determine Teta Ltd’s expected future dividend, assuming efficient capital markets.
Question 3 (20 marks)
Future Diversify Ltd (FDL) considers forming an investment portfolio that comprises shares issued by Blue Ltd and Green Ltd. The following information relates to these shares.
Blue Ltd Green Ltd
Beta of share 1.2 2.7
Expected return on the market E(rm) 15.5%
Risk-free rate of return rf 7.5%
a) Identify and explain three benefits of diversification, e.g. holding a portfolio comprising different shares compared to holding any single share.
b) Determine the weightings of Blue Ltd shares and Green Ltd shares in FDL’s proposed portfolio, which would allow the company to achieve an overall return of 18% for the portfolio?
c) Determine the beta of FDL’s proposed portfolio in Part (b)?

Question 4 (20 marks)
XYZ Ltd is evaluating Project A and Project B. Either project will last 5 years and will require a new equipment to be purchased immediately. The company’s tax rate is 30% and its required rate of return for all investment projects is 10%. Assuming the company requires a minimum payback period of 2 years for all investment projects. Other information relevant to Project A and Project B is provided below.
Project A Project B
Initial cost of equipment $375 000 $450 000

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Depreciation rate - Straight line 20% 20%
Earnings before depreciation and tax (assuming no interest expense)
- Year 1 206 625 240 000
- Year 2 195 150 238 500
- Year 3 156 000 238 125
- Year 4 157 500 217 500
- Year 5 153 750 202 500
a) Should the company accept Project A or Project B based on: i) payback method, and ii) net present value (NPV) method? Explain why.
b) Compare the payback method and net present value (NPV) method based on four criteria below. You are required to refer to Project A and Project B above to illustrate your response.
1. Does the method correctly rank competing projects?
2. Does the method correctly identify wealth-increasing projects?
3. Does the method recognise the timing of the cash flows and their relative magnitudes?
4. Can management understand the results?

Question 5 (20 marks)
The Smith’s business manufactures motor vehicle parts. The business is owned and operated by two brothers whose marginal tax rate is 45% per annum. The brothers are planning to replace an old manually-operated machine with a new fully-automated machine. The information regarding the old machine and proposed replacement machine is given in the table below.
Old Machine Proposed Replacement
Original cost $60 000 $176 000

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Original expected life 10 years 4 years
Original expected salvage value $Nil $Nil
Current age 6 years Not applicable
Current market value $40 000 Not applicable
Depreciation rate Straight-line: no adjustment for expected salvage value Straight-line: no adjustment for expected salvage value
Depreciation term Original expected life Original expected life
Number and salary of operators 3 x $80 000 2 x $100 000
Annual maintenance cost $19 200 $23 200
Cost of waste materials $16 000 $4 000
Other information related to the new fully-automated machine includes:
• The maintenance workers would require special training for the new machine. Fortunately, the required training was provided to the maintenance workers three months ago when a similar machine was purchased. This training program cost $30 000. However, the company's management is not sure if they should charge 80% of this $30 000 training fee against the proposed new machine.
• Since the new machine would work faster than the old one, an additional investment of $14 000 in raw materials and work-in-process inventories would be required. The company expects to recover this extra investment at the end of the machine’s estimated useful life.
• The brothers would have to obtain a loan of $120 000 from the business’ local bank to purchase the new machine. The loan requires an interest payment at 8% per annum, which increases the company’s annual interest payments by $8 200 per year.
• The company expects that the new machines will have production capacities similar to those of the old machine.
• The company’s finance manager has estimated the same 10% per annum after-tax required rate of return on investments for both old and new machine.

a) Briefly discuss whether there are any non-incremental cash flows in the scenario. If so, explain why these costs are regarded as non-incremental.
b) Determine the after-tax initial outlay for the project.
c) Determine the annual after-tax cash flows in Years 1, 2 and 3 for the project.
d) Determine the project’s after-tax terminal cash flow in Year 4.

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