QUESTION 1 COST OF CAPITAL (15 marks) (A) Theoretical Questions

(i) A firm's capital structure and its target capital structure proportions are important determinants of a firm's weighted average cost of capital. Explain. (6 marks)

(ii) AA Mobil (AAM) is one of the half dozen major companies in the world. The firm has four primary operating divisions (upstream, downstream, chemical and global services) as well as a number of operating companies that it had acquired over the years. A recent major acquisition was ATR Energy, which was acquired in 2010 for $41 billion. The ATR Acquisition gave AA Mobil a significant presence in the development of domestic unconventional natural gas resources, including the development of shale gas formations, which was booming at the time

Assume that you have been hired to be an analysist for AA Mobil's Chief Financial officer (CFO). Your first assignment was to look into proper cost of capital for use in making corporate investments across the company's many business units. Would you recommend AA Mobil to use a single company wide cost of capital for analysing capital expenditure in all of its business units? Why or why not. Explain.

(Approx. 180 words per question)

(B) Problem Solving

(i) Drury Corporation is issuing new common stock at a market price of $27. Dividends for last year were $1.45 and were expected to grow at an annual rate of 6 for an indefinite period of time. 6 percent of the market price will be the flotation costs. Calculate the cost of equity for Drury Corporation.

(3 marks)

(6 marks)

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QUESTION 2 CAPITAL BUDGETING (25 marks) (A)Theoretical Questions

(i) (ii)

Explain how profitability index can be used in the ranking of investment proposals?

(5 marks) 'The lower the discount rate the lower the present value of a future cash

flow.' State whether this statement is true or false. Give an example to support your answer. (5 marks)

(Approx. 150 words per question)

(B) Problem Solving

HR Industries is a non- profit organization located in Haw era, New Zealand. One of the organisation's objective is to make biscuits for its snack food store. At the end of year 1, the organization purchased a biscuit cutting machine which has been used for three years now.

Management is considering to purchase a new and more efficient machine. If purchased, the new machine would be acquired at the end of year 4. Management expects to sell 300,000 boxes of biscuits in each of the next six years. The selling price is expected to average $1.15 per box.

HR Industries has two options:

• Continue to operate the old machine
• Sell the old machine and purchase a new machine.
• No trade in was to be offered by the seller of the new machine.
• The following information has been assembled to help management to decide which option is more desirable.

Old machine

New machine

Original cost of acquisition

$80,000

$120,000

Remaining useful life (at end of year 4)

6 years

6 years

Expected annual cash operating expenses:

Variable cost per bag

$0.38

$0.29

Total fixed costs

$21,000

$11,000

Estimated cash value of machines:

End of year 4

$40,000

$120,000

End of year 10

$7,000

$20,000

Assume that all operating revenues and expenses occur at the end of the year. Ignore income tax.

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Required:

1. (a)Use the net present value method to determine whether HR Industries should retain the old machine or acquire the new machine. The organisation's required rate of return is 12 percent.
2. (10 marks)
3. (b)Independent to your answer in (a), suppose the qualitative differences between the two alternatives are so slight that the management is indifferent between the two proposals. Identify and explain any qualitative factors the management should consider.
4. (5 marks)

QUESTION 3 RISK AND RETURN (30 marks) (A) Theoretical Questions

(i) Differentiate between systematic risk and non-systematic risk and why an investor should not expect to receive additional return for bearing non-systematic risk.

(Approx. 300 words) (10 marks) (ii) Describe the capital asset pricing model (CAPM) and its relationship to the

security market line (MSL).

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(B) Problem Solving (i)

(Approx. 250 words) (8 marks)

has a beta coefficient of 0.88.

New Zealand Oil & Gas Company has cash for acquisitions or producing assets,

a controlling interest in ASX-listed Cue Energy, and exploration interests offshore

New Zealand and onshore in Indonesia. The company

Required:

Estimate its cost of equity if the risk free rate is 4% and return on the broad market

index is 8%.

(4 marks)

(ii) As a finance manager of Hamilton Ace corporation, you have been supplied with the following:

A project with beta, b of 1.50 is currently under consideration for the NZ Lee Company Limited. During this time, the risk free rate of return, rf is 7 per cent and the return on market portfolio of assets, rm is 10. The project is usually expected to earn an annual rate of return of 11 percent.

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Required:

(a) If the return on the market portfolio were to increase by 10 percent, what would

be the expected required return of the of the project? (2 marks)

(b) Compute the required rate of return on this investment using the capital asset pricing model (CAPM) model. (3 marks)

(c) On the basis of your calculation in part (b), state whether you would recommend this investment. (Give reasons to support your answer). (3 marks)