Question 1 [9 marks]

Indicate whether each of the following statements is true or false and provide a brief explanation (no more than 200 words for each statement).

(a) Consider the following equally likely project outcomes:

Profit

X Y

Pessimistic prediction $ 0 $10 000

Expected outcome $10 000 $10 000

Optimistic prediction $20 000 $10 000

(i) Project Y has less uncertainty than Project X.

(ii) Project X has more variability than Project Y. (3 marks)

(b) In an efficient market, investors have opportunity to profit from publicly available information. Investors have full control of security prices by buying and selling the security according to the market price. (3 marks)

(c) Beta is the relationship between an investment’s returns and the market returns. It is a measure of the investment’s diversifiable risk. (3 marks)

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Question 2 [14 marks]

(a) You are considering three alternative investments. Investment X offers a return of 1.5% per month compound interest. Investment Y offers a payoff of $895.65 after four years in return for savings of $80 made at the end of each half-year. Investment Z requires you to deposit $440.00 now and also pays back $895.65 after four years. Required: Suggest a suitable way of choosing between these investments and rank them accordingly. (6 marks)

(b) You are given four investment alternatives to analyse. The cash flows from these four investments are as follows:

End of Year Investment ($)

A B C D

1 20,000 10,000 52,000

2 20,000 12,000

3 20,000 1,500

4 20,000 15,000

5 20,000 10,000 20,000

6 10,000 50,000 22,000

7 10,000 35,000

8 10,000 30,000

9 10,000 42,000

10 10,000 35,000 50,000

Project D has an initial outlay of -$120,000. All projects with equal life. Assume an 18% discount rate for all the investments.

(i) Find the present value of each investment. (6 marks)

(ii) Determine whether the project should be accepted of rejected and provide your reasons. (1 mark)

(iii) Rank the four investment projects accordingly. (1 mark)

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Question 3 [6 marks]

You are considering of purchasing a bond with a par value of $1,500. The bond will mature in 12 years. You are given that the investors’ required rate of return is 5% per annum.

(a) Calculate the price of the bond to the nearest cent if the coupon interest rate is 6% per annum, paid annually. (1.5 marks)

(b) Calculate the price of the bond to the nearest cent if the coupon interest rate is 6% per annum, paid half-yearly. (1.5 marks)

(c) Explain why the answers to parts (a) and (b) must be more than the par value of the bond. (3 marks)

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Question 4 [7 marks]

BSB Corporation’s ordinary shares are currently selling in the market for $33. Dividends of $2.30 per share were paid last year, and the company expects annual earnings and dividend growth to be 5% per annum.

(a) Given that you require a 15% rate of return, what is the value of a share to you? (2 marks)

(b) Determine the return that can be expected from a BSB Corporation share. (2 marks)

(c) Should you purchase BSB Corporation shares? Explain your reasons (no more than 200 words). (3 marks)

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Question 5 [19 marks]

You are considering of purchasing two mutually excusive machines that perform the same task. Machine A has an expected life of 3 years and expected future net cash flows in each of years 1-3 of $11,500. Machine B has an expected life of 9 years and expected future net cash flows in each of years 1-9 of $5,800. The initial investment required for each machine is $18,000. Assume a required rate of return of 13.5% per annum.

(a) Calculate each machine’s payback period. (3 marks)

(b) Calculate each machine’s net present value. (3 marks)

(c) Calculate each machine’s internal rate of return. (3 marks)

(d) Are these machines comparable? Explain your answers. (2 marks)

(e) Compare these machines using replacement chains and equivalent annual annuity (EAA). Which machine should be selected? Support your recommendation. (8 marks)

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Question 6 [16 marks]

(Source: Petty, J.W. et al 2012, Financial Management: Principles and Applications, 6th Edition, Pearson Australia, Frenchs Forest, NSW. P. 436)

The Laser Co. Ltd has ordinary, Australian-resident share-holders and the company pays its profits as franked dividends which have a high utilisation factor in the hands of shareholders. The board of directors is considering a major investment to expand its highly technical facilities. The expansion will take a total of four years until it is completed and ready for operation. The following data and assumptions describe the proposed expansion:

(a) To make this expansion feasible, R&D expenditures of $200,000 must be made immediately to ensure that the construction facilities are competitively efficient (t=0).

(b) At the end of the first year the land will be purchased and construction on stage 1 of the facilities will begin, involving a cash outflow of $150,000 for the land and $300,000 for the technical facilities.

(c) Stage 2 of the construction will involve a $300,000 cash outflow at the end of year 2.

(d) At the end of year 3, when production begins, inventory will be increased by $50,000.

(e) The first sales from the operation of the new plant will occur at the end of year 4 and be $800,000 and continue at that level for ten years (with the final flow from sales occurring at the end of year 13).

(f) Operating costs on these sales are composed of $100,000 fixed operating costs per year and variable operating costs equal to 40% of sales.

(g) When the plant is closed, equipment will be sold for $50,000 and the land will be sold for $200,000 (t=13).

The company has a 12% required rate of return.

i. What are the cash outflows of this project? (3 marks)

ii. What are the differential annual cash flows of this project? (3 marks)

iii. What is the terminal cash flow of this project? (4 marks)

iv. Draw a cash-flow diagram for this project. (2 marks)

v. What is the NPV of this project? (3 marks)

vi. Should this project be accepted? (1 mark)

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Question 7 [29 marks]

(Source: Petty, J.W. et al 2012, Financial Management: Principles and Applications, 6th Edition, Pearson Australia, Frenchs Forest, NSW. P. 437)

It is the end of the financial year and the management team of Tiger Air, a budget airline that provides short-haul flights in the South-East Asia region, is reviewing the functionality of its aircraft. It has come to the airline’s attention that one of its aircraft has experienced a considerable amount of down time and is in need of an overhaul. The overhaul is expected to cost a total of $3 million, including $2 million for engine replacement, $400,000 for safety devices, $200,000 for new carpet and seating, and $200,000 for repainting the aircraft. After the overhaul, it is expected that the aircraft will have a useful life of five years, at which time it can be sold for a salvage value of $300,000. Until the aircraft is scrapped, the annual operating cost, including fuel, will be $1,500,000. It is also agreed that the cost of the overhaul, except for the painting expense, will be recorded as an investment (in the accounting book), to be depreciated using the straight-line method over the remaining useful life of the aircraft. The cost of painting, on the other hand, will be treated as an expense that produces an immediate tax benefit.

Parallel to the overhaul option, the management team is also considering the purchase of a new aircraft. If a new aircraft is purchased, the existing aircraft will have to be scrapped in the current condition at approximately $750,000. The new aircraft will cost $7,500,000 but will be longer lasting, having an estimated useful life of 10 years. This new aircraft is expected to be more efficient in fuel consumption and therefore the annual operating cost is estimated to be $900,000. The new aircraft will also be depreciated for accounting purposes using the straight-line method down to zero, while management is hoping to fetch a salvage value of $800,000 for the aircraft.

Tiger Air’s existing after-tax cost of capital is 8%, which is deemed to be appropriate for a capital-budgeting decision of this nature. The tax rate that the company faces is 30%. Calculate the equivalent annual cost for the overhaul versus purchase option and advise Tiger Air on the most economically viable course of action.

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