ACG32: FINANCE AND INVESTMENT - STUDY PERIOD 1, 2008

ACG 23 BUSINESS FINANCE OUA STUDENTS - STUDY PERIOD 3, 2016 ASSIGNMENT 2 INFORMATION General Assignment Details Completion - Individual Basis This assignment must be completed and submitted on an individual basis. The assignment answers need to be prepared using Microsoft Word and must be submitted via Learnonline. You need to include your name and University of South Australia student ID number in your assignment document. Do not include the assignment questions in your assignment submission. Other Assignment Details Show all working in assignment calculations. In questions involving the use of a financial calculator, you are required to show all financial calculator steps in your answer. If you answer a question using a financial calculator, you do not need to detail the equivalent mathematical formula. Please refer to the Unit Outline for other details in relation to this assignment task. Question 1 (Total marks for this question = 26 marks) A manufacturing company is considering replacing an old machine with a new one. The riskfree rate of return is given as 4% p.a. The yearly return for the share market is given as 12%. Suppose a listed company has a beta value of 0.75. The shareholders of the company cannot benefit from imputation credits. The old machine was purchased 5 years ago for $100,000 and is expected to have a useful life of 10 years and zero salvage value. If the company sold the old machine today, it would receive $40,000. The new machine will cost $75,000 and is expected to have a useful life of 5 years with zero salvage value. The old machine has maintenance costs of $10,000 per year whereas the new machine has maintenance costs of $1,000 per year. The new machine will also reduce the cost of defects from $5,000 per year to $1,000 per year. The company uses straight-line depreciation, and assumes a company tax rate of 30%. (a) What is the investors' required rate of return for the company's shares? (2 marks) (b) If the company is either a taxation category 1 or a taxation category 2 company, to which taxation category does the company belong? Would capital budgeting for the company be performed on a before-tax or an after-tax basis? (2 marks) (c) If the old machine were sold today identify the annual depreciation expense and the tax savings for the old machine. (3 marks) (d) Calculate the initial outlay for the project. (2 marks) (e) Calculate the annual depreciation expense for the new machine and determine the net cash flows for years 1-5 of the project. (6 marks) (f) Discuss what the payback period identifies and therefore why it is readily used. (2 marks) _______________________________________________________________________________ 1 (g) Calculate the payback period. What are the weaknesses of the payback period method for evaluating projects? (3 marks) (h) Calculate the net present value (NPV), profitability index (PI) and internal rate of return (IRR) of the project. (4 marks) (i) Is the project an acceptable investment? Explain your answer. (2 marks) Question 2 (Total marks for this question = 13 marks) You are a portfolio manager who invests in Australian equities. Being a successful manager you have been approached by Mrs. Dalrymple, a high new wealth individual who has an interest in investing into your fund. She is curious with the management of risk you utilise, and is particularly interested with the effects of diversification. (a) Provide a brief discussion of approximately 300 words for Mrs. Dalrymple detailing the risks inherent in stock returns and the effects of diversification. (6 marks) Part of your job is to identify stocks for placement into the portfolio. You wish to evaluate the characteristics of Bryson and Sons, a publicly listed Australian company. Over the coming year the firm's economists estimate the probability of a number of different economic situations and the expected return of the economy in each situation. As Bryson and Sons is closely integrated with the Australian economy the rates of return for the economy can be used for Bryson and Sons. The probability for economic situation is listed in the below table: Boom Growth Stagnant Recession Probability 10% 30% 40% 20% Return 25% 12% 5% -17% (b) Identify the expected return and standard deviation of Bryson and Sons. (5 marks) (c) Treasury bills currently pay a return of 5%. On the basis of the individual returns and standard deviations of Bryson and Sons and the T-bill would you recommend the purchase of Bryson and Sons? Why or why not? (2 marks) _______________________________________________________________________________ 2 Question 3 (Total marks for this question = 12 marks) As a junior analyst in a small trading firm your responsibilities are to use some basic valuation methods using your finance skills. Predominately you investigate stocks and bonds and report your findings for further analysis. Your boss has tasked you to value a 4-year corporate bond with a face value of $1,000 which pays a semi-annual coupon of 8% p.a. The yield to maturity of similar rated bonds is 9% p.a. The bond is issued at its face value. (a) Draw the relevant aspects of this bond using a cash flow diagram. (3 marks) (b) Based on your cash flows identify the intrinsic value of the bond. (2 marks) (c) After one year the price of the bond has decreased to $930 based on expectations of an increase in domestic interest rates. What is the Yield to Maturity of the bond? (3 marks) Your boss also wishes you to value a stock. This stock has just paid dividends of $0.32 per share. You estimate the growth rate in dividends at 3% p.a., growing indefinitely. Treasury bills currently pay 4% p.a. and the market risk premium over recent history is estimated at 5% p.a. Beta is estimated at 1.2 for this stock. (d) Identify the required rate of return for the company. (2 marks) (e) Calculate the intrinsic value for this stock. (2 marks) Question 4 (Total marks for this question = 17 marks) Tiffany is a socialite who was endowed with a large amount of old money. Over time Tiffany, through her social activities, has spent large amounts of this money, but has realised the need to plan for retirement. After talking to friends in the investment industry she invested $200,000 of her remaining money into a fund. (a) If Tiffany wanted to have $2,000,000 in her account by retirement in 20 years what rate of return on her investment would she need to achieve? (2 marks) Tiffany is surprised by the growth of the capital in the fund. At the end of three years her money had grown to $350,000. (b) What rate of return is achieved on her money over the first three years? (2 marks) (c) Based on her goal of $2,000,000 what rate of return would she now have to achieve to reach this goal? (2 marks) Tiffany is unconvinced that the fund will continue to grow at this rate, and is convinced that the fund may possibly depreciate in value. She now aims to protect this money by investing the $350,000 into a term deposit with additional monthly payments into the account, paid at the end of each month. The term deposit pays 8% p.a. with interest compounded quarterly. (d) How large are the monthly deposits such that the fund will grow to $2,000,000 in the remaining 17 years? (4 marks) An alternative investment opportunity has occurred for Tiffany to invest her current amount of $350,000. The investment has an upfront fee of $1,000 with fixed weekly payments into the account of $400 which are paid at the beginning of the week. The account pays a slightly lower rate of return at 7.75% p.a. compounded weekly. _______________________________________________________________________________ 3 (e) Given that Tiffany still wants $2,000,000 for her retirement in 17 years, identify which of the investments, either the monthly or weekly term deposit that generates the $2,000,000 the quicker. (4 marks) (f) Identify, through discussion, the difference between an annuity due, an ordinary annuity and a general annuity? (3 marks) Question 5 (Total marks for this question = 15 marks) Humperdinck Inc, an organisation that investigates opportunities for potential investment has recently promoted you out of the mailroom. You have some experience in valuation having spent a summer internship at an investment bank. Your boss, easing you into the role, expects you to provide an analysis of Hillock & Hummock Ltd, an Australian owned company. Hillock and Hummock produced 2,500 marmot pelts in the past financial year which had an average selling price of $2,000. Variable costs are estimated at 70% of revenue, with an additional warehouse rent, wages and licences fixed at $750,000 for the year. Hillock and Hummock have only one depreciable asset, initially purchased at $1,500,000 which they depreciate in a straight line to $0 over 10 years. They are currently still depreciating this asset. Hillock and Hummock have an interest expense from the debt they hold of $50,000, and the applicable corporate tax rate is 20%. (a) Provide an income statement for Hillock and Hummock for the past financial year. (7 marks) There are currently 1 million ordinary shares outstanding for Hillock and Hummock and they pay out 90% of their after tax earnings to investors. (b) Identify Hillock and Hummock's earnings per share, the dividend per share and the total dollar amount of dividends paid to shareholders. (2 marks) The founder of the company, Mr. Glass, who is now retired, has no other income other than the revenue from his 300,000 Hillock and Hummock shares and is a resident of Australia. The dividends are expected to be fully franked. (c) Determine the taxable income for Mr. Glass. (4 marks) (d) Based on the tax rates provided below, determine the size of the refund or tax payable for Mr. Glass. Note: Do not include the Medicare Levy or any other levies, offsets or rebates in your calculations. (2 marks) Tax rates Income $0 - $18,200 $18,201 - $37,000 $37,001 - $80,000 $80,001 - $180,000 Rate 0% 19% 32.5% 37% Source: Australian Taxation Office, 2016 _______________________________________________________________________________ 4 Question 6 (Total marks for this question = 17 marks) Your friend approaches you to provide advice on the mechanisms within the financial market, how prices are set and the concept of the incorporation of information into prices. (a) With reference to efficient markets provide your friend with a short, 300 word description regarding how prices are set and how this information is incorporated into prices. In addition, what is the implication for finance managers and their decision making process? (6 marks) In the same vein, your friend wishes to know more about the mathematics of returns and has provided the historical prices of Algotech Ltd. She does not understand the difference between arithmetic and geometric returns of a stock or the implications of both of these averages. Your objective is to show her the differences between these. Algotech Ltd. has not paid any dividends in recent history. The following table contains the prices provided by your friend: Year 0 1 2 3 4 5 Price 100 110 95 90 105 100 (b) Identify the yearly returns for Algotech Ltd. (2 marks) (c) Calculate the arithmetic and geometric average rates of return. (3 marks) (d) With specific reference to the averages and prices of Algotech Ltd, describe the differences and implications to investors of the two averages. (6 marks) Total Marks for Assignment = 100 Marks _______________________________________________________________________________ 5