MBA6002 Corporate Finance Assignment Solutions to Questions
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MBA6002 Corporate Finance
Part A
QUESTION A-1) Mr. Daniel Johns would like to have $75,000 in 15 years. To accumulate this amount, Daniel plans to deposit each year an equal sum in the Wacpak Bank, which will earn 8% interest compounded annually. His first payment will be made at the end of the year.
Required:
a) How much must Daniel deposit annually to accumulate this amount?
b) If Daniel decides to make a large lump-sum deposit today in the Wacpak
Bank instead of the annual deposits, how large should this lump-sum deposit
be?
c) At the end of five years Daniel expects to receive a royalty payment of
$20,000 and deposit this in the bank towards his goal of $75,000 at the end
of 15 years. In addition to this deposit, how much must Daniel deposit in
equal annual deposits to reach his goal?
d) If, instead of earning 8% p.a., Daniel now only earns 6.5% p.a. on his
deposits, briefly discuss what impact will this will have on Daniel’s ability to
accumulate the desired $75,000 at the end of 15 years.)
QUESTION A-2) In October 2007, the Los Angeles Times newspaper reported that the winner of a national lottery prize in California had the misfortune to be both bankrupt and in prison for fraud. The lottery prize was $9,420,713, and was to be paid to the winner in 19 equal annual installments (not adjusted for the time value of money) commencing 1 year from today.
The Bankruptcy Court judge ruled that the prize should be sold off to the highest bidder and the proceeds used to pay off the creditors of the now unfortunate prison inmate.
Required:
a) If the interest rate on a similar risk-free security were 8% p.a., how much
would you have been prepared to bid for the prize?
b) The Providence Insurance Company was reported to have offered to pay
$4.2 million for the prize today. Calculate the approximate return that this
company was looking for.
c) Briefly comment on why your answer to section b) is reasonable based on
your knowledge of the relationship that exists in finance between price and
d) If Providence Insurance wanted to pay the sum specified ($4.2 million) in 3
equal annual payments commencing today, what amount would you advise
the recipient of the payments to accept if they are happy with the yield
calculated in section c)? It is assumed that the equal annual payments
calculated for this part of the question are adjusted for the time value of
PART B
Question B-1) you own 250 McCormick Resources’ preference shares, which currently sell for $38.50 per share and pay annual dividends of $3.25 per share.
Required:
a) What is your expected return?
b) If you require an 8% p.a. return, given the current price, should you
sell or buy more shares in McCormick Resources? Justify your
Question B-2) An issue of bonds with a par value of $1,000 matures in 14 years and pays 9% p.a. The current market price of the bonds is $1,100 and your required rate of return is 10% p.a.
Required:
a) Compute the bond’s expected rate of return.
b) Determine the value of the bond to you, given your required rate of return.
c) Should you purchase the bond given your previous calculations?
Question B-3 You has included the following securities in your investment portfolio:
Required:
a) Calculate the expected return of the portfolio assuming that investment
returns are likely to remain relatively stable.
b) Calculate the beta of the portfolio.
c) Briefly comment on how your investment portfolio is likely to perform in the
following year where the expectations are now unfavorable for positive
returns in investment markets.
Question B-4) The expected return for the general market in France is 12.8%, and the risk premium in that market is 4.3%. Alight Ltd., a company listed on the French Stock Exchange has a beta of 0.82.
Required:
a) What is the corresponding required rate of return for alight Ltd. shares?
b) What is the major assumption that allows investors to use beta instead of
standard deviation as the relevant measure of risk for a proposed investment
in alight Ltd. shares?
PART C
Albert Corp. wants to calculate its weighted average cost of capital (WACC). The company’s CFO has collected the following information:
The company’s long-term bonds currently offer a yield to maturity of 8 percent. The coupon rate of interest on bonds is 9%.
The company’s stock price is $32 a share (P0 = $32).
The company recently paid a dividend of $2 a share (D0 = $2.00).
The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).
The company’s target capital structure is 75 percent equity and 25 percent debt.
The company’s tax rate is 30 percent.
Required:
a) Using the constant dividend growth model, calculate the company’s cost of equity.
b) Calculate the company’s weighted average after-tax cost of capital (WACC).
c) In your calculation of WACC, explain your choice of interest rate on bonds (borrowings). Did you use the 8% yield to maturity or the 9% coupon rate?
d) Describe the primary use of the WACC when making capital budgeting decisions.
e) Explain whether or not a company should use the SAME WACC to evaluate ALL of
its investment proposals.
PART D
Question D-1 Fuchs Manufacturing is an assembly business run by a sole proprietor whose margin l tax rate is 47% p.a. The owner is considering the purchase of a new fully-automated machine to replace an older, manually-operated one. Details of the old machine are as shown in Table 1 below:
|
Original Cost: |
$20,000 |
Depreciation Rate: |
Straight-line – no adjustment for expected salvage value |
|
Original Expected |
10 years |
Depreciation Term: |
Original expected life |
| Original Expected Salvage Value: |
$Nil | Number and Salary of Operators: |
1 x $17,000 |
| Current Age: | 5 years | Annual Maintenance cost: |
$7,000 |
| Current Market Value: |
$15,000 | Annual cost of | $3,000 |
Table 1
Details of the proposed replacement fully automated machine are shown in Table 2 below:
|
Original Cost:
|
$55,000 |
Depreciation Rate: |
Straight-line – no adjustment for expected salvage value |
| Original Expected Life: |
5 years | Depreciation Term: |
Original expected life |
| Original Expected Salvage Value |
$10,000 | Annual Maintenance cost: |
$2,000 |
| Number and Salary of Operators: |
$0 | Annual cost of Defects: |
$4,000 |
Table 2
Other information that has been gathered in relation to the proposed fully
automated machine that may be relevant to the capital budgeting decision is
shown below:
- The new machine would require maintenance workers to be specially trained; fortunately, a similar machine was purchased three months ago, and at that time the maintenance workers went through the $9,000 training
program needed to familiarize them with the new equipment. The firm’s management is uncertain whether or not to charge half of this $9,000 training fee toward the new project.
- In addition, because the new machine would work faster than the old one, investment in raw materials and goods-in-process inventories would need to be increased by a total of $5,000. This additional investment would be expected to be recoverable by the firm at cost at the end of the machine’s expected useful life.
- In order to purchase the new machine, Fuchs Manufacturing would have to borrow an additional $30,000 at a 10% p.a. interest rate from its local bank, resulting in increased interest payments amounting to an
additional $3,000 per year.
- Despite the proposed introduction of the new machine, it is expected that the total production capabilities of the new machine will be similar to the existing machine.
- For both the existing and proposed fully automated machine, the finance
manager of the firm has estimated an after-tax required rate of return on such
investments of 20% p.a.
Required:
In relation to the replacement proposal, please answer the following questions:
a) Briefly discuss whether you are able to identify any non-incremental cash flows in the information provided, and if so, why would they be regarded as non-incremental?
b) What would be the project’s initial outlay?
c) What are the annual differential cash flows in year’s 1 to 4 of the project’s
life?
d) What is the terminal cash flow in year 5 of the project, excluding
the regular year 5 differential cash flow from section c) of this
question?
e) Draw a timeline / cash-flow diagram for this project based on the information
included above.
f) Calculate the project’s Net Present Value (NPV).
g) Calculate the Profitability Index (PI) for the project.
h) Calculate the Internal Rate of Return (IRR) for the project.
i) Assuming that cash-flows occur regularly over the life of the project proposal
(that is, on a daily basis), if the firm requires a minimum payback period on
projects of this type of less than four years, should this project be accepted
based on the payback rules? Briefly justify your response.
j) What difference would it make to your answer to section i) if the cash flows
from the project proposal all occurred at the end of each year?
k) On an overall basis, would you recommend that Fuchs Manufacturing accept
the replacement proposal? Briefly justify your response