Question
a)What are the three important financial decision-making areas that a financial manager in a firm is responsible for? Illustrate each of the areas identified using
- a)What are the three important financial decision-making areas that a financial manager in a firm is responsible for? Illustrate each of the areas identified using examples from an organisation that you are familiar with. (5 marks)
- b)What is the goal towards which the above financial decision-making should be directed in a firm? In what ways can the pursuit of such a firm-specific goal come in conflict with the personal goals of the financial manager? (5 marks)
- c)Explain what is meant by 'portfolio' and discuss how an investor can reduce investment risk by constructing an investment portfolio. Explain in which scenario an investor is unable to reduce investment risk by constructing an investment portfolio?
- (5 marks)
Question 2
The risky portfolio A consists of 1000 shares of DREXLA and 4000 shares of OGATO. Assume that DREXLA has a share price of $6, an expected return of 18%, and a standard deviation of 22%. OGATO has a share price of $4, an expected return of 14%, and a standard deviation of 20%. The correlation between the two is 0.6, and the risk-free rate of interest is 8%.
Graph the Capital Allocation Line derived from the risk-free asset and portfolio A. (Label all axes and points carefully). b) What fraction of your portfolio must you invest in A to have a portfolio standard deviation of 12%? (10 marks)
Question 3
- a)Beta Ltd has current earnings of 90 cents per share. These earnings are expected to continue growing at the rate of 6% per annum in the foreseeable future. Assume 30% of the earnings are paid out as dividends.
- Determine the expected share price of the company using the dividend growth model. Assume that a cost of equity of 10% is applicable.
- b)Cameron paid $980 for a 15-year bond 10 years ago. The bond pays a coupon of 10 percent semiannually. Cameron is planning to sell the bond today. He found that the bond value needs to be adjusted upward with the current inflation rate of 7.56%.
- If he sells the bond today, what would be his realized yield?
c) Lincoln, Inc. expects to pay no dividends for the next four years. It has projected a growth rate of 35 percent for the next four years. After four years, the firm will grow at a constant rate of 6 percent. Its first dividend to be paid in year 5 will be worth $4.25.
If your required rate of return is 20 percent, what is the stock worth today?
(3*5 = 15 marks)
Question 4
You are financial advisor to an entrepreneur, who is planning to establish a new firm. The business plan indicates that the firm requires $50 million to purchase initial buildings and equipment and is expected to generate annual net operating cash flow of $10 million in perpetuity. Three alternative financing plans are being considered:
Scenario 1: equity of $50 million;
Scenario 2: equity of $25 million and bank loan of $25 million at an interest rate of 6% per annum;
Scenario 3: equity of $35 million and bank loan of $15 million at an interest rate of 14% per annum.
- a)Assuming no taxes for each of the scenarios above, you are required to calculate return to equity holders and weighted average cost of capital. Also, together with gearing ratios, you need to interpret these results on the basis of the Modigliani and Miller's propositions on a firm's capital structure.
- b)Justify why it is necessary to assume 'a world without taxes' under MM proposition pertaining to a firm's capital structure.
c) How will your results differ if you apply 30% corporate tax rate? Show all calculations.
Question 5
(20 marks)
Elda Ltd currently has a 3:2 debt-equity capital structure with $10 million in ordinary shares. The company's expected earnings before interest and tax (EBIT) is $2.4 million, and the dividend payout ratio is 100%. The cost of debt is 9% per annum. The company plans to issue $5 million additional debt and use the new debt to buy back ordinary shares at $8 per share.
a)
Illustrate Elda's existing capital structure in light of the following calculations assuming no tax:
Earnings available to shareholders The current number of shares Earnings per share and dividend Cost of equity capital is
b)
c)
Weighted average cost of capital
The company's market value (6 marks)
Illustrate Elda's New capital structure in light of the following calculations assuming 30% corporate tax rate:
Question 6
The number of shares that was bought back. Number of shares under the new structure Earnings available to shareholders
Earnings per share and dividend
Difference in old Vs new EPS Cost of equity capital
Weighted average cost of capital Market price of shares
Discuss the implications of your answer to part (a) for the following:
(8 marks)
The relationship between higher earnings per share and dividend with respect to higher ordinary share price and higher shareholder value.
Effect on cost of equity and cost of debt. Justify your answer
Effect on Share price and shareholder wealth
Effect on EBIT due to increase in financial leverage
(6 marks)
You are a top finance graduate from Monash University. Your friend Shane is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Shane's rich uncle has left him $20 million in his will. Having been a management student, Shane partied while you studied. In fact he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Shane watched an interview with the Maharishi Yogi Berra. The Maharishi claims material wealth lies beneath the ground in Dromana. It is clear from the tone of the interview, the title of the documentary was "An interview with a crackpot," that the interviewer and the "experts" on the show think the Maharishi is insane. However, Shane believes in the Maharishi because his management training taught him to believe in gurus (Peter Drucker, for example). Shane decides to use his new found fortune to prove the Maharishi correct, making himself one of the richest people in Australia in the process!
Shane knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million. In addition the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment.
You and Shane meet with the Maharishi and after several hours of meditation the Maharishi provides you with estimated annual after-tax cash-flows. These cash-flows are in millions and are provided to you below in table 2-1. Shane thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the
numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%. Should Shane invest his fortune based on the crackpot's ideas?
Table: Projected Cash Flows
Projected Cashflow
Projected Cashflow
Year 1
$1,500,000
Year 11
$2,500,000
Year 2
$3,278,000
Year 12
$2,500,000
Year 3
$5,000,000
Year 13
$2,500,000
Year 4
$6,450,000
Year 14
$2,500,000
Year 5
$2,500,000
Year 15
$2,500,000
Year 6
$2,500,000
Year 16
$2,500,000
Year 7
$2,500,000
Year 17
$2,500,000
Year 8
$2,500,000
Year 18
$2,500,000
Year 9
$2,500,000
Year 19
$2,500,000
Year 10
$2,500,000
Year 20
$2,500,000
Calculate the Net Present Value and the Internal Rate of Return.
Would your decision change if you used a discount rate of 18% and 10%.
(20 marks)
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