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Financial Management
Exercise 1 Australian Land Ltd is planning a rights issue to raise funds. The subscription price is $16.50 and they want to raise $4,125,000. The current market price of their shares is $18.00 and there are currently 1,750,000 shares on issue. Q1 - How many new shares need to be issued to raise the funds required? Shares to issue = Amount to be raised / subscription price = 4 125 000 / 16.50 = 250 000 shares Q2 - How many shares will entitle each holder to purchase one new share in the rights issue? Number of shares needed = number of shares currently on issue / number of new shares = 1 750 000 / 250 000 = 7 shares Financial Management Revision Questions Exercise 1 Q3 - What is the value of a right? R0 = n × (M – S) ÷ (n + 1) = 7 × (18 – 16.5) ÷ (7 + 1) = $1.3125 Q4 - What would the ex-rights price per share be if the rights issue is fully subscribed? X = (n × M + S) ÷ (n + 1) = (7 × 18 + 16.5) / (7+1) = $17.81 Financial Management Revision Questions Exercise 2 Q1 - Cash Discounts: If a supplier offers a 1.5% discount for payment of an account within 21 days or net 60 (1.5/21, N60), what is the effective interest rate if you do not pay until 60 days after receipt of the account? Ø Paying on the 60th day is equivalent to paying interest of $1.5 on a $98.5 loan: Ø 1.5 / 98.5 = 0.0152 on a 39-day loan. Note that 60 – 21 = 39 days loan Ø EAR = (1 + i)m − 1 = (1.0152)365/39 − 1 = 0.1516 = 15.16% Q2 - Economic Order Quantity: The estimated demand for the widgets for the coming year is 25,000, order costs are $200 per order and carrying costs are $8 per widget. What is the EOQ? Q* = (2 × T × F ⁄ CC)0.5 = (2 × 25 000 × 200/8)0.5 = 1 118 widgets Financial Management Revision Questions Exercise 3 AY Ltd is looking at two different capital structures to finance the start of its operations. Structure A: Long term debt of $100,000 paying a 16% coupon and 100,000 shares issued at $2.00 each. Structure B: Long term debt of $200,000 paying a 17% coupon and 50,000 shares issued at $2.00 each. AY Ltd pays tax @ 30%. What is the break-even EBIT? Financial Management Revision Questions Exercise 3 Break-even Point when EPSA = EPSB. Therefore: [(EBIT - 16,000)(1 - 0.30)] / 100,000 = [(EBIT - 34,000)(1 - 0.30)] / 50,000 Divide both sides by (1 - 0,30) and 10,000 (EBIT - 16,000) / 10 = (EBIT - 34,000) / 5 Multiply both sides by 10 EBIT – 16,000 = (EBIT - 34,000) × 10/5 -EBIT = 16,000 - 68,000 EBIT = 52,000 Financial Management Revision Questions Exercise 4 An investor has sought the advice of a financial planner to add some shares to his holding of government bonds. The bonds are worth $30,000 and pay a return of 3.6% p.a. The investor and the planner have agreed that he should invest $120,000 in four companies, as indicated by the table below. Q1 - Calculate the expected return of the combined portfolio consisting of the shares and the original holding of government bonds. Q2 - Calculate the beta of the combined portfolio consisting of the shares and the original holding of government bonds. Financial Management Revision Questions Company Return Beta Amount invested ABC Ltd 14.80% 1.6 $40,000 DEF Ltd 11.65% 1.15 $20,000 GHI Ltd 9.20% 0.8 $30,000 JKL Ltd 8.85% 0.75 $30,000 Exercise 4 Q1 - Calculate the expected return of the combined portfolio consisting of the shares and the original holding of government bonds. Ø First we need to work out the weights of each investment. Ø Total amount invested = 40 + 20 + 30 + 30 + 30 = 150 wABC = 40/150 = 0.27 wDEF = 20/150 = 0.13 wGHI = 30/150 = 0.2 wJKL = 30/150 = 0.2 wGOV = 30/150 = 0.2 Ø The E[RP] is: E[RP] = 0.27×14.8% + 0.13×11.65% + 0.2×9.2% + 0.2×8.85% + 0.2×3.6% = 9.84% Financial Management Revision Questions Exercise 4 Q2 - Calculate the beta of the combined portfolio consisting of the shares and the original holding of government bonds. Ø Now we can calculate the beta of the portfolio: βP = 0.27×1.6 + 0.13×1.15 + 0.2×0.8 + 0.2×0.75 + 0.2×0 = 0.8915 Financial Management Revision Questions Exercise 5 If ABC Ltd has a Beta of 1.6 and expected return of 14.8%. What is the return on the market based on the assumption that ABC is trading in equilibrium and the risk free rate is 3.6%? RABC = Rf + ABC × (Rm − Rf) 14.8% = 3.6% + 1.6(Rm – 3.6%) 14.8% = 3.6% + 1.6Rm - 5.76% 16.96% = 1.6Rm Rm = 10.6% Financial Management Revision Questions Exercise 6 SHT, an Australian company, is considering an investment in the U.S. Interest rates in Australia are currently 6.5% p.a., whilst in the U.S. they are 5.0% p.a. The current AUD/USD exchange rate is 0.8500. Q1- Based on interest parity, what would you forecast the spot AUD/USD exchange rate to be one year from now and after two years? E(St) = S0 × [(1+Rtc) ÷ (1+Rc)]t E(S1) = S0× [(1+Rtc)/(1+Rc)]1 = 0.85× [ (1.05)/(1.065)] = 0.8380 Q2- Based on interest parity, what would you forecast the spot AUD/USD exchange rate to be after two years? E(S2) = S0× [(1+Rtc)/(1+Rc)]2 = 0.85× [ (1.05)/(1.065)]2 = 0.8262 Financial Management Revision Questions Exercise 7 An investment in the US costs USD 5 million, with expected cash inflows of USD 3.4 million in year 1 and USD 4.8 million in year 2. Currently, interest rates in Australia are 6.5% p.a., whilst in the U.S. they are 5.0% p.a. The required rate of return for a similar investment in Australia is 12% and the current AUD/USD exchange rate is 0.8500. What is the NPV of the investment? 1- Compute the RRRtc: [(1 + 0.12) × (1+0.05) ÷ (1+0.065)] − 1 = 0.1042 2- Calculate the NPV using the foreign currency CFs and RRRtc = −5 + 3.41 + 0.1042 ! + 4.81 + 0.1042 " = 2.02 3- Convert the NPV to AUD: 2.02 1 0.85 = . Financial Management Revision Questions Exercise 8 Executive Air Charter is considering the expansion of its operations and needs to calculate its cost of capital for the new venture. Executive Air Charter has $5, 7% preference shares, with a book value of $200 million. The last sale of Executive Air Charter’s preference shares was at a price of $3.50. Q1 - What is the market value of Executive Air Charter’s preference shares? First we need to find the number of shares on issue: Number of shares = book value of shares / issue price = 200 000 000 / 5 = 40 000 000 shares The market price of the preference shares is then P = 40 000 000 x 3.5 = $140 000 000 Q2 - What is the required rate of return on Executive Air Charter’s preference shares? Rp = D/P Rp= [0.07 x 5 / 3.5] = 0.1 = 10% Financial Management Revision Questions Exercise 9 What is the weighted average cost of capital for Air Charter if they have a target capital structure of 34% debt and 13% preference shares? The market required rate of return on debt is 6%, preference shares 10% and equity 18%. The tax rate is of 30%. Equity financing =1 – (0.34+0.13) = 0.53 WACC = 0.34 x 0.06 x (1-0.3) + 0.53 x 0.18 + 0.13 x 0.1 = 0.1227 = 12.27% Financial Management Revision Questions Exercise 10 RRC is to replace its aging plant maker. The new plant will cost $300,000 and will have a life of four years. RRC’s latest loan was negotiated at 8%. RRC is looking to lease the plant. The lease has four payments annually in advance of $80,000 plus a residual payable at the end of the lease (year 4) of $30,000. The tax deprecation for this type of plant is three years straight line. RRC estimates the plant will be worth $15,000 at the end of the four years. Q1 - What are the cash flows from leasing for years 0 to 3? -56,000 Q2 - What are the cash flows from leasing for year 4? -10,500 Financial Management Revision Questions 0 1 2 3 4 Lease Payment -80 -80 -80 -80 Tax Saving 24 24 24 24 Residual -30 Sale of Machine 15 Tax 4.5 Total -56 -56 -56 -56 -10.5 ü 4-year lease with annual payments of $80,000, payable in advance ü Tax savings 80000 x 30% = $24000 ü Residual value $30000 and resale value $15000 ü Loss on sale (30000 - 15000) x 30% = 4500 Exercise 11 AIJ is considering constructing a new warehouse. The construction cost for the warehouse is $650,000. Fittings will cost an additional $575,000. The warehouse will be built on land AIJ purchased for $200,000 a few years ago, and which is currently worth $375,000. The value of the land is expected to double over the 10-year life-span of the warehouse and the tax rate is 30%. AIJ has paid Sydney Consulting $148,000 to design the warehouse and has arranged to finance the cost of the construction with a 12% p.a. interest- only loan requiring payments of $180,000 per year. AIJ will sell one of its vans if it moves to the new warehouse. It would sell one which is fully depreciated for tax purposes and that could be sold for $8,000. In addition, moving to the new warehouse would yield a once-off reduction in inventory of $970,000. What are the cash flows at the start? Financial Management Revision Questions Exercise 11 The construction cost for the warehouse is $650,000. Fittings will cost an additional $575,000. Outflow at the start The warehouse will be built on land AIJ purchased for $200,000 a few years ago, and which is currently worth $375,000. Opportunity cost. Outflow at the start The value of the land is expected to double over the 10-year life-span of the warehouse and the tax rate is 30%. Inflows at the end AIJ has paid Sydney Consulting $148,000 to design the warehouse Sunk cost. Ignore Financial Management Revision Questions Exercise 11 Has arranged to finance the cost of the construction with a 12% p.a. interest-only loan requiring payments of $180,000 per year. Financing decisions. Ignore AIJ will sell one of its vans if it moves to the new warehouse. It would sell one which is fully depreciated for tax purposes and that could be sold for $8,000. Inflow, start In addition, moving to the new warehouse would yield a once-off reduction in inventory of $970,000. Inflow at the start (and outflow at the end) Financial Management Revision Questions Exercise 11 Cash flow at the start Land -375,000 Warehouse -650,000 Fixtures & fittings -575,000 Sale Delivery truck 8,000 Tax on sale (0-8000)30% -2,400 Inventory 970,000 Total -624,400 Financial Management Revision Questions Exercise 12 What is the Net Present Value (NPV), Profitability Index (PI) and payback period of the following cashflows if the required return is 12%? Financial Management Revision Questions Spring 2021 YEAR AMOUNT $ 0 -27 000 1 7 000 2 4 000 3 5 000 4 5 000 5 21 000 Exercise 12 Q1 - What is the Net Present Value (NPV) of the cashflows from the table below if the required return is 12%? Q2 - What is the Profitability Index (PI) of the cashflows from the table below if the required return is 12%? Q3 - What is the payback period of the cashflows from the table below if the required return is 12%? Financial Management Revision Questions YEAR AMOUNT Pay back PV @12% 0 - 27,000 - 27,000 - 27,000 1 7,000 - 20,000 6,250 2 4,000 - 16,000 3,189 3 5,000 - 11,000 3,559 4 5,000 - 6,000 3,178 5 21,000 15,000 11,916 NPV 1,091 Profitability index = (NPV + initial cost)/initial cost PI = (1091+27,000)/27,000 PI = 1.04 Payback Period is 4 years plus part of 5 = 4 + 6000/21000 = 4.3 years Exercise 13 Janet invests $15,000 in a five year term deposit with her bank at an interest rate of 5.5% p.a. If she makes no withdrawals during the five-year period and interest is added to the account each year, how much will she receive in five years’ time? FV = PV ( 1 + i )n = 15,000 × (1.055)5 = $19,604.40 Financial Management Revision Questions Exercise 14 Your uncle has a superannuation policy that promises to pay $1,250,000 on his 60th birthday. He is currently 35 years old. The fund earns 12% p.a., compounding monthly. What is the value of his policy today? Ø Number of years to be discounted: 60 - 35 = 25 Ø Number of compounding periods: n = 25 × 12 = 300 Ø Per period interest rate: i = 0.12 ÷ 12 = 0.01 Ø Future value: FV = $1,250,000 Solution PV = FV × (1 + i)-n = 1,250,000 × (1+ 0.01)-300 = $63,168.11 Financial Management Revision Questions Exercise 15 What is the price of a $100,000 ten-year bond that was issued two years ago, if it will mature in eight years’ time? Interest is paid semi-annually, and the last coupon payment was made yesterday. The coupon rate is 12% p.a., with semi-annual compounding. The yield is 14% p.a., with semi-annual compounding. c = 0.12 ÷ 2 = 0.06 i = 0.14 ÷ 2 = 0.07 n = 8 × 2 = 16 FV = $100,000 PMT = c × FV = 0.06 × 100,000 = $6,000 • Solution: PV = PMT × [(1 − (1 + i)-n) ÷ i] + FV × (1 + i)-n = 6,000 × [(1 – (1 + 0.07)-16) ÷ 0.07] + 100,000 × (1 + 0.07)-16 = $90,553.35 Financial Management Revision Questions Exercise 16 The preference shares of a company are currently trading for $15.60 per share. What is the required return on the company’s preference shares, if the annual preference dividend is $1.50 per share? P0 = D1 ÷ r ⟹ r = D1 ÷ P0 = 1.5 ÷ 15.60 = 0.0962 (or 9.62%) Financial Management Revision Questions Exercise 17 An investor has been offered shares in CHC, a new business venture. For the first four years of its operation, CHC does not expect to pay a dividend, as it plans to expand its business. At the end of Year 4, the managers of CHC expect to pay the first dividend of $0.50. They then expect the dividend to grow indefinitely at a rate of 12% p.a. What price should the investor pay for CHC shares, if he expects a return of 40% p.a. on his investment? !______!______!______!______!______! ➠ ∞ 0 1 2 3 4 5 $0.50 $0.50 × 1.12 The share price at the end of Year 3 is P3 = D4 ÷ (r − g) = 0.50 ÷ (0.40 - 0.12) = $1.7857 Hence, the share price today is: P0 = P3 × (1 + r)-3 = 1.7857 × (1.40)-3 = $0.65 Financial Management Revision Questions Exercise 18 Katana Industries intends to purchase new equipment for its factory, at a cost of $240,000. The equipment is expected to produce the following cost reductions: • $140,000 reduction in Year 1 • $80,000 reduction in Year 2 • $60,000 reduction in Year 3 • $20,000 reduction in Years 4 and 5 What is the NPV if the required rate of return for such an investment is 11% p.a.? The NPV of the investment is NPV = -240,000 + 140,000 × (1.11)-1 + 80,000 × (1.11)-2 + 60,000 × (1.11)-3 + 20,000 × (1.11)-4 + 20,000 × (1.11)-5 = $19,971.05 Since NPV > 0, Katana should purchase the equipment Financial Management