Week 12 Sample Exam Solutions

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Swinburne University of Technology *

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80005

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Finance

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Jan 9, 2024

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Page 1 PAST EXAM QUESTIONS AND SOLUTIONS Question 1 a) You are offered an investment that will return you three $7000 payments. The first payment will occur three years from today. The second will occur in six years from today, the third will follow in the following year i.e. seven years from today. If you can earn 9 percent, i) What is the most this investment is worth today? $13408 ii) What is the future value of the cash flows? $24511 b) You have determined you can afford to pay $350 per month toward a new convertible sports car. You see an advertisement in the paper for a bank loan at the rate of 15% pa and you want to make monthly payments over the next 4 years. i) How much can you borrow? $12576 c) Your company is considering an issue of preference shares. The market is currently expecting a return of 7 percent and your company expects earnings per share to be $10.10 and the dividend for preference shares to be $1.40. i) What will be the issue price of a preference share? $20 d) Answer the following questions i) What is an NIR? Nominal Interest rate ii) What is an EAR? Effective annual rate iii) What is the difference between NIR and EAR? Compounding iv) If an interest rate is given as 10 percent compounded daily what do we call this rate. NIR e) Fantastic Growth Ltd, a high technology company, has been growing at the rate of 20 percent per year. You believe that this growth rate will last for two more years and then drop to 8 percent per year thereafter. Total dividends just paid were $4 million for 8 million shares, and the required return is 15 percent. i) What should the share price be today? $9.46 Question 2 The following information has been taken from the Statements of Financial Position and Financial Performance for Ergo Ltd for the year ended 31 December 2004. $ Net profit after taxes 400,000 Retained earnings 1.1.2004 300,000 700,000 Less Dividends on ordinary shares 240,000 Dividends on preference shares 56,000 Retained earnings 404,000 ASSETS Inventory 240,000 Accounts receivable 164,000 Land and buildings 2,400,000

Page 2 Plant and equipment 1,800,000 4,604,000 LIABILITIES Accounts payable 300,000 Bank overdraft 500,000 12% debentures, $100 par value 1,000,000 1,800,000 SHAREHOLDERS FUNDS 14% preference shares $10 issue value 400,000 Ordinary shares $1 issue value 2,000,000 Retained earnings 404,000 2,804,000 Additional information • The nominal rate of interest on the bank overdraft is 10 per cent per annum. Interest is calculated monthly. • The debentures are currently selling at $93.50 each and mature in four years time. • The preference shares are currently selling at $9.50 each. • The ordinary shares are selling at $1.20 each. Dividends are expected to grow at 5% indefinitely. • The company income tax rate is 30 cents in the dollar. Using the above information, calculate the weighted average cost of capital for Ergo Ltd. Show all workings (use 2 decimal places). $‘000 Weight% Rate% Bank overdraft 500 .12 7.33 0.88 Debentures 935 .22 9.97 2.21 Pref Shares 380 .09 14.73 1.33 Ord. Shares 2400 .57 15.5 8.83 4215 100.00 13.25 Question 3 Roberto Enterprises is concerned that exporting to South East Asia will impact on its share price and is seeking a full analysis of the determinants of share price. At the moment the company has a risk return rating on its shares of 15.5%, determined by using a beta factor of 1.25. The risk free rate is 5.5%. Required: a) What is the risk premium for Roberto Enterprises? 10%

Page 3 b) What is the market risk premium? 8% c) Give i) Two examples of market risk Interest Rate., Oil prices ii) Two examples of individual risk CEO dismissed, Legal action Ross page 361 d) What risk is measured by beta? Explain your answer. Systematic Risk Ross page 366 e) What does a beta of 1.25 inform shareholders about the risk of Roberto Enterprises? Explain your answer. More riskier than the market f) Should shareholders be compensated for bearing the total risk associated with the returns of the individual company? No – principle of diversification g) Plot Roberto Enterprises and the market portfolio using a SML diagram (Security Market Line Diagram). Draw a SML diagram and identify the position of i) Roberto Enterprises ii) Market portfolio iii) Risk Free Rate Label your axes. Question 4 Modigliani and Miller developed a theory describing a firm’s optimal capital structure, ranging from a basic model assuming no corporate taxes, to an intermediate model including corporate taxes, and ultimately a model providing for costs of financial distress. Describe in detail the optimal capital structure for a company in each of the following circumstances, and sketch appropriate diagrams where needed: 1 1.25 Risk Return 15.5 13.5 Rf 5.5

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Page 4 i) No corporate tax Refer Ross page 689 ii) Corporate tax Refer Ross page 690 iii) Corporate tax and costs of financial distress. Refer Ross page 695 Question 5 a) What are the main differences between corporate debt and equity? Refer Ross page 526 and page 545 b) Explain what is meant by a 10 percent $100 par non-cumulative, convertible, redeemable, non-participating preference share. Refer Ross page 556 c) The Melbourne Cup Company Ltd currently has 30 million shares outstanding. The shares sell for $3.75 per share. To raise $36 million for a new trophy machine, the firm is considering a rights issue at $2.40 per share. i) What is the value of a right in this case? 90c ii) What is the ex-rights price? $3.30 Question 6 The directors of Aussie Spirit Rowing Ltd are interested in a new type of rowing boat that ejects a rower when they are exhausted. This new project has caused a lot of controversy but the directors believe that they can sell 50 units per year to countries that compete in the sport of international rowing. The selling price will be $50 000 per unit and the variable costs per unit will be 40 percent of revenue. The product should have a 4-year life. The directors require a 20 percent return on new products such as this one. Fixed cost for the project will be $750 000 per year. The company will need to invest a total of $1 500 000 in manufacturing equipment. This equipment may be depreciated at 15 percent straight line. In 4 years, the equipment will be worth half of what the company paid for it. The corporate tax rate is 30%. Required: a) Prepare a table of Cash Flows b) Calculate i) Net Present Value (NPV) $ 373,814 ii) Internal Rate of Return (IRR) 31.06% iii) Payback Period 2.53 YEARS c) Make recommendations to accept or reject the new project with full explanations of why the criteria you have used justifies your decision. ACCEPT – HIGH IRR AND + NPV

Page 5 0 1 2 3 4 OUTLAY (1500) REV 2500 2500 2500 2500 VARIABLE (1000) (1000) (1000) (1000) TAX (450) (450) (450) (450) FIXED (750) (750) (750) (750) TAX 225 225 225 225 DEP-TAX 67.5 67.5 67.5 67.5 SALVAGE 750 TAX (45) (1500) 592.5 592.5 592.5 1297.5 Question 7 You are considering an investment in venture capital that will return nothing in the first three years, $50,000 in the fourth year and $400,000 a year in perpetuity after that. What is the present value of the investment, given an interest rate of 8% per annum? $3711900.76 You want to buy a $10,000 car and have it paid off in 1.5 years. How much are your monthly repayments assuming the current rate is 10% compounded monthly? $600.57 Question 8 The cash flow forecasts for two mutually exclusive projects are as follows: Cash Flow in Dollars Year Project A Project B 0 -$100 -$100 1 30 49 2 50 49 3 70 49 Note : Use a table to illustrate your answer Which project would you choose if the opportunity cost of capital is 5 percent? Show calculations to support your answer. Which would you choose if the opportunity cost of capital is 12 percent? Show calculations to support your answer. Why does your answer change? Indicate the interest rate where your answer changes 7.796% Use a graph to illustrate answer

Page 6 PROJECT A PROJECT B 5% 34.39 33.43 12% 16.47 17.69 Question 9 Explain why the risk of a portfolio of two stocks can be less than the individual risk of each of those stocks individually. Portfolio Risk – Systematic Risk Individual Risk – Systematic and Unsystematic Diversify unsystematic or unique risk If a company has a β of 1.5 what does this mean? Systematic risk is 1.5 times that of the market therefore compensation is 1.5 times market risk Describe the risks for which shareholders would be compensated for under the assumptions of the capital asset pricing model. Systematic risks or market risks such as changes in interest rates What is the Security Market Line? Graphical representation of CAPM What is the CAPM and what does it tell us? Model that prices share based on risk ie Rf + (Rm – Rf ) Beta Question 10 Define the following terms (and give an example where appropriate) IPO Secondary Market ASX Efficient Market Hypothesis Rights Issue Refer to your text book

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Page 7 Question 11 The Directors of the Ritchiemond Football Club (a tax paying entity) are very concerned about the club’s lack of success over recent years. They are seriously considering the purchase of 20 new football robots that are being manufactured in Tegucigalpa. These robots will replace 20 of the players the club fields each week. The robots cost $15,000 each, with an additional charge for painting in club colours and transporting them to the club’s home ground. This amounts to $2,500 per robot. The robots will be depreciated on a straight line basis at twenty percent per annum. The directors believe the robots, after being programmed to mark, handball and kick with both feet, can win most of their games and so generate an additional $100,000 in gate receipts each year. Not having to pay the current list of players will save the club an extra $30,000 a year. The robots will have a playing career of five years, after which time their central processing units can no longer think or see. They will then be sold off (for a total of $20,000) to a company that paints them white, puts whistles in their mouths, and uses them as umpires. Ritchiemond’s required rate of return is 12 percent and the corporate tax rate is 30%. Calculate: a) Net Present Value (NPV ) $61679 b) Internal Rate of Return (IRR) 18.79% a) Payback Period 3.125 year e) Present Value Index 1.176 $’000 0 1 2 3 4 5 Cost (350000) Sales 100000 100000 100000 100000 100000 Cost Savings 30000 30000 30000 30000 30000 Tax (39000) (39000) (39000) (39000) (39000) Dep. Tax 21000 21000 21000 21000 21000 Salvage 20000 Tax (6000) Total (350000) 112000 112000 112000 112000 126000 Question 12: Transuburban Ltd, a major construction company, is planning to submit a quote to build the Robert Mitcham Tollway. However, the company finance manager is unsure of the required rate of return to use in her calculations. She has offered you a free G tag if you could provide information on the appropriate ‘discount rate’. To help you with your calculations, she has tabled the following extracts from the company’s latest Financial Statements

Page 8 Selected Financial data as at 31 December 2003: SHAREHOLDERS FUNDS Ordinary shares Issue price $2.00 each, fully paid $20,000,000 10% Preference shares Issue price $2.00 each, fully paid $10,000,000 Retained Profit $14,500,000 LIABILITIES Accounts Payable $ 1,500,000 Debentures $24,000,000 Bank Overdraft $ 8,000,000 Provision for Long Service Leave $10,000,000 Additional Information: • 24,000 debentures have been issued with a coupon rate of 6.5%. They mature in 5 years time. Similar debentures are currently yielding 10%. • The bank overdraft carries an interest rate of 8%. Interest is charged monthly. • The current dividend paid is 16 cents per share. This dividend is expected to grow indefinitely at 5% per annum. • The expected market return on Transuburban Ltd ordinary shares is 13%. • The risk free rate of interest is 6%. • The current market price of the Preference Shares $1.80. • The company tax rate is 30 %. Required: Calculate the weighted average cost of capital (to 2 decimal places). Show all workings. MV Cost WACC Debentures 20815739 35.39 7.0 .024773 Bank Overdraft 8000000 13.6 5.8 .007888 Pref.Shares 9000000 15.3 11.1 .016983 Ord Shares 21000000 35.71 13.0 .046423 Total 58815739 100 .096067 WACC = 9.6% Question 13 What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure? Increase Earnings per share if return on assets exceeds cost of debt. Benefit tax deduction from debt ie M &M theory V (l) = V (U) + Tr x Debt BUT Increase level of financial risk Legal obligation Financial Distress

Page 9 Distinguish between: business risk, financial risk and default risk. Business Risk – the risk of future net cash flows attributed to the nature of the company’s operations. It is the risk shareholders face if the company is financed only by equity Financial Risk – the additional risk borne by shareholders because of the use of debt as a source of finance Default Risk – The chance that a borrower will fail to meet obligations to pay interest and principal as agreed Question 14 1. If you were given the choice of borrowing at an interest rate of 10% p.a. simple interest, or 9.2% p.a. compounded monthly, which should you choose? Why? Eff 9.598% cf Eff 10% therefore take the cheaper rate 2. Your brother has a debt that he may repay by paying $5,000 now or $10,000 in four years’ time. If the interest rate is 14% p.a. compounded monthly, would you advise him to repay the debt now or in four years? Eff 14.934% FV $8725 cf FV $10,000 OR PV $5000 cf PV $ $5731 OR IRR is 18.92 % therefore pay $5000 today 3. Your sister has just graduated from university and has begun employment with an investment bank. She intends to retire in 30 years from now and would like to be able to withdraw $30000 per year from her savings for a period of 20 years after retirement. She expects to earn 9% annually on her savings. Assuming end of year cash flows, what equal annual amount must your sister save during her 30 years of employment in order to be able to withdraw the desired annual amount during the 20 years of retirement? PV $273856 therefore $2009.10 payment for 30 years 4. An investor is earning $15,000 this year (payable at the end of the year) but expects to be earning $60,000 next year (payable at the end of the year). a. What is the maximum amount that the investor can consume today if the interest rate is 10 %? $63,223 b. If the investor decides to consume zero this year, how much could she consume next year? $76,500 Question 15 The BJ Company is evaluating the proposed acquisition of a new bubble gum machine. The machine’s base price is $128,000, and it would cost another $15,000 to modify it for special use by the firm. The machine is depreciated at tax rates of 25 percent. It would be sold after 3 years for $70,000. The machine would require an increase in net working capital of Inventory $10000, Accounts Payable of $4000 and Accounts Receivable of $5000. The machine would have no effect on revenues, but it is expected to save the firm $45000 per year in before tax operation costs, mainly labour. Assume a tax rate of 30 percent. The projects cost of capital is 10 percent.

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Page 10 Required a) Using a table format indicate the cash flows that are relevant for evaluating this project $ $ $ $ 0 1- 2 3 New machine (128000) Modification (15000) Tax – Dep’n 10725 10725 10725 Sale 70000 Tax – Profit on Sale (10275) Working Capital (11000) 11000 Savings on New Dryer 45000 45000 45000 Tax on cash flows ( 13500) ( 13500) ( 13500) Total (154000) 42225 42225 112950 NPV $4144 IRR 11.28 % PV Index 1.03 b) Should the machine be purchased? Justify your answer. Project should be accepted Positive NPV IRR > 10% PV Index > 1 Maximises shareholder wealth Question 16 “The essential message of portfolio theory is that diversification reduces risk” Answer the following questions asked by your potential clients a) How does diversification reduce risk? The principle of diversification is that spreading an investment across a number of assets will eliminate some, but not all, of the risk. Forming portfolios can eliminate the diversifiable risk or unique risk associated with individual assets. There is a minimum level of risk that cannot be eliminated simply by diversifying. This minimum level is labelled ‘non- diversifiable risk’ or systematic risk b) How do we measure the risk of an individual share? Give examples of such risk. A beta coefficient tells us how much systematic risk a particular asset has relative to an average asset. Examples of Systematic risk are GNP, interest rates and inflation.

Page 11 c) How do we measure the risk of a well-diversified portfolio? Give examples of such risk. The risk of a well-diversified portfolio is measured using a portfolio Beta. Multiple each asset’s beta by its portfolio weight and then add the results up to get the portfolio’s beta. . Examples of Systematic risk are GNP, interest rates and inflation. d) What risk are investors compensated for? Why? Systematic Risk as non systematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no non- systematic risk e) Use the Security Market Line to illustrate the relationship between risk and return on an individual security and explain how this line may be used to derive the return required on an individual share. SML Positively sloped straight line displaying the relationship between expected return and beta . 1.0 Beta Question 17 a) What is the difference between primary and secondary markets? Primary market is where securities are issued/traded in the first instance e.g. new co-share issues. Secondary market deals with subsequent trading of securities which have already been issued. Comprises bulk of trading in financial markets. b) Outline 2 benefits of each. Primary Market – • Direct Fund raising for companies • Strict Corporate Governance procedures for initial listing Secondary market • A capital market for the trading of marketable securities • Strict Corporate governance procedures for companies listed in a secondary market Return Rm Rf

Page 12 c) Identify 3 types of finance that a firm could use to fund a new project. d) Identify and explain 1 benefit and 1 disadvantage for two types of finance for either the firm or the investor. Advantages Disadvantages Debentures • Tax deduction of interest • No dilution of ownership • Increases Financial risk Preference Shares • Security over ordinary shares as defined dividend and usually preferential in liquidation • Can be no participation therefore no claim on profit above scheduled dividend Ordinary Shares • Reduces Financial risk • Dividends no legally required • Dilution of ownership • No tax Shield Any other type of debt or equity Question 18 The following financial information relates to the operations of Graeson’s Boats Ltd. Emmy Lou Ltd. is planning to expand its operations in the fishing industry and is viewing Graeson’s Boats Ltd. as a possible acquisition. The following figures have been extracted from Graeson’s Boats Ltd accounts. Statement of Financial Position as at 30 June 2002 $000 Current assets 14,000 Investments 11,000 Non Current assets 20,000 45,000 Current liabilities (non-interest bearing) 11,700 Debentures 11,300 Reserves 9,000 Share Capital (Issued at $1) 13,000 45,000

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Page 13 Additional information i Government bonds are currently yielding 6% per annum. ii The current market return on equity is estimated to be 14% per annum. iii A merchant banker suggests that Graeson’s Boats Ltd would have to offer a rate of 11% p.a. on any new issue of 10 year debentures. iv The current $1,000 debentures have a coupon rate of 9%, compounded semi annually, with ten years to maturity. v The company tax rate is 30%. vi Graeson’s Boats Ltd shares have recently traded at $4 and the company's financial manager believes that a beta of 1.5 is appropriate to the company. a) Estimate the cost of capital for Graeson’s Boats Ltd. Source Market Value Weight Cost % WACC % (1) (2) (3) (4) (3)x(4) Debentures 9949606 16.06% 7.7 1.24 Ord Shares 52000000 83.94% 18 15.11 61949606 100.00 16.35 WACC =16.35% b) Explain what this rate means and identify the key factors which may influence its usefulness It is the firm’s overall cost of capital. It is the overall return that the firm must earn on its existing assets to maintain the value of its shares. It is the discount rate that we use to evaluate a proposed expansion. Problems • Divisions must have similar risk profiles • Proposed projects must have a similar risk as the firm • Costs of raising funds are ignored

Page 14 Question 19 The directors of a public company are not convinced that they should follow a consultant’s recommendation to buy back equity. The company has insufficient cash to finance the buy back and therefore debt funds would have to be raised to implement the recommendation. The consultants provided a simplified commencing balance sheet (before the buy back) to illustrate what the value of the strategy would be to shareholders wealth. Assets $200,000 Equity $200,000 (200,000 $1 ordinary share) The following additional information is supplied: • Tax rate is 40% • Interest rate on debt is 10% • Earnings before interest and tax is 15% • The debt to equity ratio is to be 1:1 in the new structure • The market value of a share is $1 The revised balance sheet will be as follows: Assets $200,000 Debt $100,000 Equity $100,000 $200,000 $200,000 Required Use the above example to illustrate the quantitative advantages to existing shareholders of a buy back arrangement. Without Debt EAIT = $18,000/$200,000 = 9c EPS With Debt $200,000@15% = $30,000 EBIT ($10,000) Interest $20,000 ($8,000) Tax $12,000 EAIT/$100,000 = 12 c EPS Benefit from Debt 100,000 @5% (60%) = $3,000/ $100,000 Shares 3c per share

Page 15 Question 20 Keith will be starting a 6-month live in training course in 4 months’ time. His mother, Karen, has promised him a living allowance of $300 per month to help support him during this time. If the interest rate is 8 percent per annum, compounding monthly how much money will Karen need to set aside today to finance Keith’s allowance? Pmt 300 Fv 1758.73 I 8/12 N 4 N 6 I 8/12 Comp pv pv 1712.60 Question 21 Ann borrowed $500,000 to purchase an apartment in Port Melbourne. The loan requires monthly repayments over 15 years. When she borrowed the money the interest rate was 6 percent per annum, but 2 years later the bank increased the interest rate to 7 percent per annum, in line with market rates. The bank tells Ann she can • increase her monthly repayment (so as to pay off the loan by the originally agreed date) (First Option) or • she can extend the term of the loan (and keep making the same monthly repayments) (Second Option). Calculate a) The new monthly repayment if Ann accepts the first option; PV 500,000 N 15 X 12 I 6/12 COMP PAYMENT $4219 PV 456,275 N 13 X 12 I 7/12 COMP PAYMENT 4463 b) The extra period to the loan term if Ann accepts the second option. PV 456275 I 7/12 PAYMENT (4219) COMP N 171.34/12 = 14.28 YEARS

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Page 16 Question 22 The Two Up Casino Company has constructed a Casino at Less Vegas, in the middle of the Simpson Desert. The casino will be abandoned when the gambling licences expire after an estimated 10-year period. The following estimates of investment costs, sales and operating expenses relate to a project to supply Two Up with fresh fruit and produce over the 10 year period by developing nearby land. Investment in land is $1,000,000, farm building $200,000 and farm equipment $400,000. The land is expected to have a realisable value of $500,000 in 10 years time. The residual value of the buildings after 10 years is expected to be $50,000. The farm equipment has an estimated life of 10 years and a zero residual value. Land is not depreciated. There is an investment of $250,000 in current assets, which will be recovered at the termination of the venture. Annual cash sales are estimated to be $2,480,000. Annual cash operating costs are estimated to be $2,200,000. The required rate of return is 8% per annum and the tax rate is 30 percent. Required $’000 $’000 $’000 0 1-9 10 Land (1000) 500 Building (200) 50 Equipment (400) Working Capital (250) 250 Revenue 2480 2480 Expense (2200) (2200) Tax on cash flows (84) (84) Tax – Dep’n – Buildings 6 6 Tax – Dep’n - Equipment 12 12 Tax – Sale of Land 150 Tax – Sale of Building (15) Total (1850) 214 1149 a. NPV $19,043 b. IRR 8.18 c. Payback Period 8.64 years d. Present Value Index or Profitability Index 1.010

Page 17 c) Should you accept the project? Justify your answer. Project should be accepted Positive NPV IRR > 8% after tax PV Index > 1 Question 23 Up The Creek Adventure Company has had great success since first going public and issuing ordinary shares three years ago. Earnings and dividends have increased by 50 percent in each year and are expected to do so for two more years. Starting with the third year, growth is expected to fall to a more normal 6 percent. During the year just completed, the firm paid a dividend of $1.00 per share. The required rate of return on Up The Creek shares is 15 percent. Calculate a) What is the maximum price an investor should pay for a share in Up The Creek? $23.04 b) What would the answer be for a) above if the 50 percent growth was to last only one year rather than two? $16.67 Question 24 You have been asked to analyse the following portfolio of shares. The owner is wondering whether the return received is sufficient to justify the risks associated with each share. The following information has been collected for your analysis. The average annual market return is 12 percent and the risk free rate is 8 percent. Beta Realised annual rate of return Red Ltd 1.1 10 Blue Ltd 1.2 20 Green Ltd 0.8 8 Black Ltd 0.9 15 Required Advise the shareholder on their portfolio specifically answering their question of “whether the return received is sufficient to justify the risks associated with each share”. Show calculations to support your answer

Page 18 Beta Realised annual rate of return Expected Return Red Ltd 1.1 10 12.40 Overvalued Blue Ltd 1.2 20 12.8 Undervalued Green Ltd 0.8 8 11.2 Overvalued Black Ltd 0.9 15 11.6 Undervalued Question 25 A friend asks you about the following terms. Answer your friend by giving a definition or/and example or/and explaining each of the following terms • Risk Averse Investor – One who dislikes risk • Systematic Risk – market related or non- diversifiable risk • Dividend Yield – dividend per share divided by share price • Weak Form Efficient Market - the information contained in the past series of prices of a security is reflected in the security’s current market price • Primary Market – a market for new issues of securities where the cash proceeds go to the issuer of the securities • Secondary Market – the market where previously issued securities are traded • Equity Instrument – Funds provided by or an interest of owners of an entity • Debt Instrument – a financial contract in which the receiver of the initial cash promises a particular cash flow, usually calculated using an interest rate, to the provided of funds. Question 26 Answer the following questions a) What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure? Present value of the tax benefit from the future interest payments. Compared to Greater Financial Risk b) Distinguish between: business risk, financial risk and default risk. a. Business risk – the risk of future net cash flows attributed tot the nature of the company’s operations. It is the risk shareholders face if the company is financed only by equity b. Financial risk - the additional risk borne by shareholders because of the use of debt as a source of finance c. Default risk – the chance that a borrower will fail to meet obligations to pay interest and principal as agreed

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Page 19 c) With corporate taxes, what is the optimal capital structure for a company? Borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. Borrow up to the point where your weighted average cost of capital is minimised. Question 27 Always A Winner Ltd. is considering expanding its gambling network. The Managing Director of the company, Mr GG, has offered you a good tip for the races if you could provide information on the appropriate ‘discount rate’ for calculating the viability of the proposed project. To help you with your calculations, he has tabled the following extracts from the company’s latest Financial Statements Selected Financial data as at 31 December 2002: SHAREHOLDERS FUNDS $ Ordinary shares Issue price $1.00 each, fully paid 20,000,000 10% Preference shares Issue price $2.00 each, fully paid 15,000,000 Retained Profit 14,500,000 LIABILITIES Debentures 30,000,000 Bank Overdraft 7,000,000 Provision for Long Service Leave 10,000,000 Additional Information: • 30,000 debentures have been issued with a coupon rate of 8%. They mature in 4 years time. Similar debentures are currently yielding 12%. • The bank overdraft carries an interest rate of 12%. Interest is charged quarterly. • The current dividend paid is 12 cents per share. This dividend is expected to grow indefinitely at 5% per annum. • The expected market return on Always A Winner ordinary shares is 11%. • The risk free rate of interest is 6%. • The current market price of the Preference Shares $1.50. • The company tax rate is 30 %.

Page 20 Required Calculate the weighted average cost of capital (to 2 decimal places). Show all workings. Source Market Value Weight Cost % WACC % (1) (2) (3) (4) (3)x(4) Bank Overdraft 7000000 0.080 8.78 0.70 Debentures 26355181 0.305 8.40 2.56 Ordinary Shares 42000000 0.485 11.00 5.34 Preference Shares 11250000 0.130 13.33 1.73 86605181 1.000 10.33 WACC =10.33% Question 28 A firm pays a dividend of $3 million today, and also invests $3 million today that gives an average return of 25%. This will increase the current value of the firm by $348,214. The current opportunity cost of capital is 12%. What is: I. The value of the firm before the investment decision is made. $ 6 million II. Dividends the firm would pay next year. $3.75 million III. Net Present Value of the Investment $348 214 IV. Present Value of the Firm $6 348 214 Question 29 Fisher Separation Theorem provides a single decision rule for a firm’s investment decisions I. What is the decision rule? The decision rule is that management’s role is to maximise the present value of the firm’s investments in productive assets. II. What is the implication of the theorem? The benefit of the theorem is that it is one decision rule that management can follow to aid in optimally allocating the firm’s resources among the competing interests of a multitude of shareholders.

Page 21 Question 30 Sun Industries is considering the expansion of its operation by extending its plant. The new plant, with a life of 10 years, will cost $1,500,000 to build on existing land owned by Sun. The plant will have zero scrap value. The land has an estimated market value of $750,000. Additional spare parts of $150,000 and additional inventory of $600,000 will be required to support the new operation. The annual revenue and expenses associated with the project are estimated to be as follows: Revenue $2,250,000 Operating Expenses $1,450,000 Increased Overhead Expense $150,000 Increased Head Office Expense $180,000 Allowable depreciation $150,000 The after tax weighted average required rate of return appropriate to the project is 13% and the corporate tax rate is 30%. Required: Evaluate the project for Sun Industries Year 0 1-9 10 Outlay (1,500,000) Land (opp-cost) (750,000) Spare Parts (150,000) 150,000 Inventory (600,000) 600,000 Revenue 2,250,000 2,250,000 Op. Expenses (1,450,000) (1,450,000) Increased Overhead expenses (150,000) (150,000) Increased Head Office Expenses (180,000) (180,000) Tax on cash flows (141,000) (141,000) Tax benefit of depn 45,000 45,000 (3,000,000) 374,000 1,124,000 NPV ($749,644) IRR 7.05% Question 31 I. Define and distinguish between a: a. Rights Issue and Share Issue. Rights issue is an issue of shares to existing shareholders in proportion to their existing shareholding where they have the right to purchase these shares at a lower subscription price than the market price. This protects their proportionate interests in the company .

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Page 22 Raising of funds from the issue of ordinary or preference shares directly to the public i.e. IPO or private placement, or rights issue or dividend reinvestment plan b. Primary Market and Secondary Market. Primary Market – a market for new issues of securities where the cash proceeds go to the issuer of the securities Secondary Market – the market where previously issued securities are traded II. What do the following acronyms stand for: a. IPO Initial Public Offering b. ASX Australian Stock Exchange III. Define the following terms a. Market Capitalisation The total market value of all the shares of a company on issue. A direct measure of the total wealth of shareholders that is invested in the company b. Financial Asset A claim to a series of cash flows against some economic unit. For eg A bank account or a share in a company Question 32 The following abstracts from the Income Statement and Balance Sheet relate to the operations of Douglas Ltd for the year ended 31 December 2004 $ Net profit after taxes 200,000 Retained earnings 1.1.2004 150,000 350,000 Less Dividends on ordinary shares 120,000 Dividends on preference shares 28,000 Retained earnings 202,000 ASSETS Inventory 120,000 Accounts receivable 82,000 Land and buildings 1,200,000 Plant and equipment 900,000 2,302,000 LIABILITIES Accounts payable 100,000 Bank overdraft 200,000 12% Debentures, $100 par value 500,000 Loan, interest at 15%, repayable over 20 years 100,000 900,000

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Page 23 SHAREHOLDERS EQUITY 14% Preference shares $10 issue value 200,000 Ordinary shares $1 issue value 1,000,000 Retained earnings 202,000 1,402,000 Additional information • The nominal rate of interest on the bank overdraft is 10 per cent per annum and interest is calculated half yearly. • The debentures are currently selling at $97 each and mature in four years time. • The Loan interest is repayable over twenty years. • The preference shares are currently selling at $9.50 each. • The ordinary shares are selling at $2.40 each with a dividend growth rate of 6%. • The company income tax rate is 30 %. Required: Using the above information, calculate the weighted average cost of capital for Douglas Ltd. Show all workings to 2 decimal places. . Source Market Value Weight Cost % WACC % (1) (2) (3) (4) (3)x(4) Bank Overdraft 200 000 .0592 7.17 0.04 Debentures 485 000 .1437 9.10 1.31 Loan 100 000 .0296 10.50 0.31 Preference Shares 190 000 .0563 14.73 0.83 Ordinary Shares 2 400 000 .7112 11.30 8.04 3 375 000 100 10.53 WACC = 10.53%

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Page 24 Question 33 Part A Ben will be starting a 4 year apprenticeship in 12 months’ time. His mother, Mary, has promised him a living allowance of $100 per month to help support him during this time. Required If the interest rate is 8 percent per annum, compounding monthly how much money will Mary need to set aside today to finance Ben’s allowance? Pmt 100 I 8/12 N 4 x 12 Comp PV $4096.19 Fv $4096.19 I 8/12 N 1 x 12 Comp PV $ 3782.26 Part B Jon borrowed $300,000 to purchase an apartment in Hawthorn. The loan requires monthly repayments over 10 years. When he borrowed the money the interest rate was 6 percent per annum, but 2 years later the bank increased the interest rate to 7 percent per annum, in line with market rates. The bank tells Jon he can • increase his monthly repayment (so as to pay off the loan by the originally agreed date) (First Option) or • he can extend the term of the loan (and keep making the same monthly repayments) (Second Option). Calculate I. The new monthly repayment if Jon accepts the first option; and II. The extra period to the loan term if Jon accepts the second option. PV 300,000 N 10 X 12 I 6/12 COMP PAYMENT $3330.61 PAYMENT $3330.61 N 8 X 12 I 6/12 COMP PV $253,443.49 PV $253,443.49 N 8 X 12 I 7/12 COMP PAYMENT $3455.37 An extra $124.76 per month PV $253,443.49 I 7/12 PAYMENT ($3330.61) COMP N 100.885/12 = 8.4 YEARS An extra 5 months

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Page 25 Question 34 Part A A stock has a beta of 1.1. A security analyst who specializes in studying this stock expects its return to be 15 per cent. Suppose the risk-free rate is 8 per cent and the market-risk premium is 6 per cent. Required: Is the analyst pessimistic or optimistic about this stock relative to the market’s expectations? Explain your answer with calculations Analyst expects 15% CAPM gives 8% + 1.1 (6%) = 14.6% Analyst is optimistic relative to markets expectations. Analyst believes the stock is undervalue in the market place Part B What is an investment portfolio? How can investors reduce investment risk by constructing an investment portfolio? An Investment Portfolio is the name for a group of single assets held by an investor .There are 2 types of risk unsystematic and systematic. The risk that can be reduced is unsystematic risk. This consists of business risk factors specific to the individual company such as a strike. However the portfolio does not eliminate systematic risk but you can construct a portfolio to follow the average risk as measured by movements in the all ordinaries index. Question 35 Part A What is meant by the term ’Capital Structure’? The amount of debt relative to equity used by a corporation What is meant by the term ‘Optimal Capital Structure’? Borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. Borrow up to the point where your weighted average cost of capital is minimised. Part B Paradise Ltd operates in a very stable environment and confidently expects it s current EBIT of $5 000 000 pa to be maintained indefinitely. The after-tax cost of equity is determined to be 15%. Institutional borrowing is available at an interest rate of 10%. The corporate tax rate is 30%. I. Determine the value of the firm $23 333 333 II. What will be the value of the firm If Paradise Ltd borrows $10 000 000 and uses the borrowed money to repurchase shares? $26 333 333

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Page 26 Question 36 Quick Wash Ltd, a suburban car washing franchise, is struggling to cope with the demand following the introduction of water restrictions. The management is considering the purchase of an additional washing bay and machine. Two models have been evaluated as suitable for their needs. The ‘BloDry’ costs $60,000 to purchase and $6,000 a year to operate. It has an economic life of seven years. The other machine is the “RapidDry’, costing $90,000, with operating costs of only $4000 per year and a life of 10 years. The relevant discount rate is 12 per cent. Ignoring taxes and depreciation, compute the Annual Equivalent Cost (AEC) for both. Which car washing machine should be purchased? Blo Dry Rapid Wash PMT 6000 PMT 4000 N 7 N 10 i 12 i 12 Comp PV 27382.54 + 60000 = 87382.54 Comp PV 22600.89 + 90000 = 112600.89 PV 87382.54 PV 112600.89 N 7 N 10 i 12 i 12 Comp PMT $19147.06 Comp PMT $19928.57 Buy BloDry – lower AEC 3 Question 37 The following information is taken from the Statement of Income and Balance Sheet for Littlebrain Ltd for the year ended 31 December 2004 $ Net profit after taxes 280,000 Retained earnings 1.1.2004 150,000 430,000 Less Dividends on ordinary shares 180,000 Dividends on preference shares 48,000 Retained earnings 202,000 ASSETS Inventory 202,000 Accounts receivable 500,000 Land and buildings 2,000,000 Plant and equipment 1,000,000 3,702,000

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Page 27 LIABILITIES Accounts payable 100,000 Bank overdraft 800,000 11% debentures, $100 par value 1,000,000 1,900,000 Shareholders' funds 8% preference shares $10 issue value 600,000 Ordinary shares $1 issue value 1,000,000 Retained earnings 202,000 1,802,000 Additional information • The nominal rate of interest on the bank overdraft is 10%. Interest is calculated monthly. • The debentures are currently selling at $96.50. They mature in seven years. • The preference shares are currently selling at $9.50 each. • The ordinary shares are selling at $2.40 each with a dividend growth rate of 6%. • The company income tax rate is 30 cents in the dollar. Required: Calculate the WACC to 2 decimal places Source Market Value Weight Cost % WACC Bank Overdraft 800000 .169 7.33 1.24 Debentures 965000 .204 8.23 1.68 Ordinary Shares 2400000 .507 13.95 7.07 Preference Shares 570000 .120 8.42 1.01 4735000 1.00 11% Question 38 Nowater Filters Ltd has recently completed a $50,000 marketing study. Based on the results, Nowater has estimated that 10,000 of its new water filters could be sold annually over the next four years at a price of $150 each. Variable costs per filter would be $100, and fixed costs would total $300,000 per year. Start-up costs include $500,000 to build new machinery and $150,000 to buy land. The $500,000 machine will be depreciated using the straight line method to zero over the project’s life. At the end of the project’s life, the machine and land are expected to be sold for an estimated $225,000. The land’s value is not expected to change. Increased working capital (mostly inventory) is expected to be $25,000. The company tax rate is 30% and Nowater Filters Ltd has a required return of 12% on all investments.

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Page 28 Required Using a table to illustrate your cashflows, calculate the: a. NPV b. IRR c. Payback Period d. Present Value Index (PVI) NPV $8709.87 IRR 12.53% Payback Period 3.35 years Present Value Index (PVI) 1.0129 $’000 $’000 $’000 0 1-3 4 Machinery (500,000) Land (150,000) Salvage 225000 Working Capital (25000) 25000 Sales 1,500,000 1,500,000 Variable Costs (1,000,000) (1,000,000) Fixed Costs (300,000) (300,000) Tax on cash flows (60,000) (60,000) Tax – Dep’n 37,500 37,500 Tax - Salvage (22,500) Total (675 000) 177 500 405 000 Question 39 a) Calculate the value of a bond that matures in 12 years and has a face value of $1000. The coupon rate is 8% paid semi-annually and the prevailing market yield is 7%. FV 1000 PMT 40 N 24 I 305 COMP PV 1080.29 b) Quickwash Ltd has just paid an ordinary dividend of $1.25. This dividend is expected to grow at an annual rate of 6 percent indefinitely. • If the current market price is $16.50, what is the required rate of return? • If the required rate of return is 10.50 percent, what is the value of the share? c) You want to buy a $15,000 car and have it paid off in 2.5 years. How much are your monthly payments assuming the rate is 9 percent compounded monthly?

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Page 29 B: Quickwash price Price $16.50 K = 14.03% k= 10.50 p = $29.44 C: Pv 15000 N 30 I 9/12 FV 0 PMT $560.22 Question 40 A firm invests $2 million that gives an average return of 50%. This will increase the current value of the firm by $600,000 to $5.4 million. The current opportunity cost of capital is 15%. What is: a. The value of the firm before the investment decision is made . $4.8 million b. Dividends the firm would pay today. $2.8 million c. Net Present Value of the Investment $600,000 d. Present Value of the Firm $5.4 million Question 41 Part A a. What does a beta coefficient measure? Beta coefficient is the amount of systematic risk present in a particular risky asset relative to an average risky asset. b. Why can’t systematic risk be diversified away? It is a market risk that affects almost all assets to some degree Refer page 365 Ross text Part B a. The risk –free rate is 5% p.a. The expected return on market is 9%. If a particular share has a beta of 0.80, what is its expected return based on the CAPM? 8.2% b. If another share has an expected return of 14%, what is the beta? 2.25 Part C We have two securities: Share Beta Expected return Company I. 1.20 13% p.a. Company II. 0.80 10% p.a.

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Page 30 What would the risk-free rate have to be, if shares are correctly priced. 13 = x + 1.2 (y – x) (y – x) = ¾ = .75 13 = x + 9 10 = x + .8 (y-x) 13 = x + 1.2 (7.5) x = 4 3 = x + .4 (y-x) 10 = x + .8 (7.5) Question 42: Part A The two propositions of Modigliani and Miller are part of the foundation of contemporary finance. [Page 673 Ross et al] State these two propositions The propositions are 1. The value of the firm is independent of the capital structure 2. the cost of equity of the firm is a positive linear function of its capital structure Part B Modigliani and Miller‘s Proposition II shows that the firm’s cost of equity can be broken down into two components. The first component depends on Business risk whilst the second component is reflective of financial risk. Define and give an example of • Business Risk • Financial Risk • Total risk Business Risk – the risk of future net cash flows attributed to the nature of the company’s operations. It is the risk shareholders face if the company is financed only by equity Financial Risk – the additional risk borne by shareholders because of the use of debt as a source of finance Total Risk – The total systematic risk of the firm’s equity - ie the total of business risk and financial risk Question 43 f) You are offered an investment that will return you three $7000 payments. The first payment will occur three years from today. The second will occur in six years from today, the third will follow in the following year i.e. seven years from today. If you can earn 9 percent, i) What is the most this investment is worth today? $13408 ii) What is the future value of the cash flows? $24511

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Page 31 g) You have determined you can afford to pay $350 per month toward a new convertible sports car. You see an advertisement in the paper for a bank loan at the rate of 15% pa and you want to make monthly payments over the next 4 years. i) How much can you borrow? $12576 h) Your company is considering an issue of preference shares. The market is currently expecting a return of 7 percent and your company expects earnings per share to be $10.10 and the dividend for preference shares to be $1.40. i) What will be the issue price of a preference share? $20 i) Answer the following questions i) What is an NIR? Nominal Interest rate ii) What is an EAR? Effective annual rate iii) What is the difference between NIR and EAR? Compounding iv) If an interest rate is given as 10 percent compounded daily what do we call this rate. NIR j) Fantastic Growth Ltd, a high technology company, has been growing at the rate of 20 percent per year. You believe that this growth rate will last for two more years and then drop to 8 percent per year thereafter. Total dividends just paid were $4 million for 8 million shares, and the required return is 15 percent. What should the share price be today? $9.46 Question 44 Modigliani and Miller developed a theory describing a firm’s optimal capital structure, ranging from a basic model assuming no corporate taxes, to an intermediate model including corporate taxes, and ultimately a model providing for costs of financial distress. Describe in detail the optimal capital structure for a company in each of the following circumstances, and sketch appropriate diagrams where needed: iv) No corporate tax Refer Ross page 689 v) Corporate tax Refer Ross page 690 vi) Corporate tax and costs of financial distress. Refer Ross page 695 Question 45 d) What are the main differences between corporate debt and equity? Refer Ross page 526 and page 545 e) Explain what is meant by a 10 percent $100 par non-cumulative, convertible, redeemable, non-participating preference share. Refer Ross page 556

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Page 32 f) The Melbourne Cup Company Ltd currently has 30 million shares outstanding. The shares sell for $3.75 per share. To raise $36 million for a new trophy machine, the firm is considering a rights issue at $2.40 per share. i) What is the value of a right in this case? 90c ii) What is the ex-rights price? $3.30 Question 46 The directors of Aussie Spirit Rowing Ltd are interested in a new type of rowing boat that ejects a rower when they are exhausted. This new project has caused a lot of controversy but the directors believe that they can sell 50 units per year to countries that compete in the sport of international rowing. The selling price will be $50 000 per unit and the variable costs per unit will be 40 percent of revenue. The product should have a 4-year life. The directors require a 20 percent return on new products such as this one. Fixed cost for the project will be $750 000 per year. The company will need to invest a total of $1 500 000 in manufacturing equipment. This equipment may be depreciated at 15 percent straight line. In 4 years, the equipment will be worth half of what the company paid for it. The corporate tax rate is 30%. Required: d) Prepare a table of Cash Flows e) Calculate i) Net Present Value (NPV) $ 373814 ii) Internal Rate of Return (IRR) 31.059% iii) Payback Period 2.53 YEARS f) Make recommendations to accept or reject the new project with full explanations of why the criteria you have used justifies your decision. ACCEPT – HIGH IRR AND + NPV 0 1 2 3 4 OUTLAY (1500) REV 2500 2500 2500 2500 VARIABL E (1000) (1000) (1000) (1000) TAX (450) (450) (450) (450) FIXED (750) (750) (750) (750) TAX 225 225 225 225 DEP-TAX 67.5 67.5 67.5 67.5 SALVAG E 750 TAX (45) (1500) 592.5 592.5 592.5 1297.5 Question 47

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Page 33 Jack Black has an endowment of $50,000 today and $0 next year. He can invest $10,000 in Project A which will generate $15,000 next year, $20,000 in Project B which will generate $22,000 next year, and $10,000 in Project C which will generate $12,000 next year. These projects are not divisible ie you must invest in the whole project . The market rate of interest is 15% per annum. 1 Rank the projects in order of rate of return A,C,B 2 Which projects should Jack undertake? A,C 3 If Jack wants to consume $35,000 today what is the maximum consumption he can have next year? $ 21250 A 10 15 50% B 20 22 10% C 10 12 20% 10000 50% 15000 10000 20% 12000 5000 Borrow 15% (5750) Repay Loan 35000 SPEND 21250 50000 ENDOWMENT Question 48 You are considering an investment in venture capital that will return nothing in the first three years, $50,000 in the fourth year and $400,000 a year in perpetuity after that. What is the present value of the investment, given an interest rate of 8% per annum? $3711900.76 You want to buy a $10,000 car and have it paid off in 1.5 years. How much are your monthly repayments assuming the current rate is 10% compounded monthly? $600.57 Question 49 Explain why the risk of a portfolio of two stocks can be less than the individual risk of each of those stocks individually. Portfolio Risk – Systematic Risk Individual Risk – Systematic and Unsystematic Diversify unsystematic or unique risk If a company has a β of 1.5 what does this mean? Systematic risk is 1.5 times that of the market therefore compensation is 1.5 times market premium

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Page 34 Describe the risks for which shareholders would be compensated for under the assumptions of the capital asset pricing model. Systematic risks or market risks such as changes in interest rates What is the Security Market Line? Graphical representation of CAPM What is the CAPM and what does it tell us? Model that prices share based on risk ie Rf + (Rm – Rf ) Beta Question 50 Define the following terms (and give an example where appropriate) IPO Secondary Market ASX Efficient Market Hypothesis Rights Issue Refer to your text book Question 51 What are the potential advantages and disadvantages to a company’s shareholders if the company increases the proportion of debt in its capital structure? Increase Earnings per share if return on assets exceeds cost of debt. Benefit tax deduction from debt ie M &M theory V (l) = V (U) + Tr x Debt BUT Increase level of financial risk Legal obligation Financial Distress Distinguish between: business risk, financial risk and default risk. Business Risk – the risk of future net cash flows attributed to the nature of the company’s operations. It is the risk shareholders face if the company is financed only by equity Financial Risk – the additional risk borne by shareholders because of the use of debt as a source of finance Default Risk – The chance that a borrower will fail to meet obligations to pay interest and principal as agreed

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