finance-FINC 5001 Capital Markets and Corporate Finance

FINC 5001 Capital Markets and Corporate Finance

Practice Final Exam

Suggested Solutions

Suggested time: 150 minutes

Question 1 (20
marks)

Modigliani and Miller (M&M)
hypothesized that both dividend policy and capital structure policy are
irrelevant in determining the value of a firm. Outline the arguments they used
to reach their positions, including the assumptions underlying those
arguments. With reference to relevant
academic literature, discuss why the M&M hypotheses might not hold in
practice.

Solution:
Outline assumptions of perfect capital
market:
1. No costs
of trading shares
2. No costs
of issuing shares
3. All
market participants have the same information
4. No
personal or corporate taxes
5. Individuals
borrow and lend at the same rate as the company.

Students need to be able to reproduce
proofs of both dividend and capital structure irrelevance arguments (for
example those on pp. 353-355 and pp .392-394) OR use their own variation on these
proofs.

Students then need to illustrate at least
one example each of how relaxing the assumptions above might affect make
dividend AND capital structure policy relevant.

Question 2 (25
marks)

Sovereign Ltd (SOV) declared a dividend of $0.40 on
10 March 2009. Sovereign’s shares will go ex-dividend on 6 April 2009. It had
previously declared a dividend on 14 September 2008. The share price, index and
bond data around the time of the dividend declaration were as follows.

Date

Sovereign Stock Price ($)

Index (pts)

Accumulation Index (pts)

10 year Government Bonds (% p.a.)

2 March 2009

2.44

4320

10589

5.48

3 March 2009

2.42

4352

10659

5.44

4 March 2009

2.39

4299

10549

5.34

5 March 2009

2.41

4333

10660

5.41

6 March 2009

2.45

4358

10711

5.50

9 March 2009

2.66

4410

10854

5.49

10 March 2009

2.89

4450

10946

5.46

11 March 2009

3.20

4397

10835

5.47

12 March 2009

3.34

4431

10914

5.45

Market analysts have determined that the standard
deviation of excess daily returns of SOV is 1.43%, whilst the standard
deviation of the excess daily returns on the Index is 0.47% and the
Accumulation Index is 0.48%. The coefficient of correlation between SOV and the
Index is 0.64, whilst the coefficient of correlation between SOV and the Accumulation
Index is 0.58.

(i)
Using this information, determine the abnormal returns for SOV on each of
the days from 3 March 2009 to 12 March 2009. Present your calculations in a
table format. (15 Marks)

Solution:

Question 2

Date

Stock Return

Index Return

Accum Return

Daily Bond Yield

CAPM Return

Abn Return

2-Mar-08

3-Mar-08

-0.008196721

0.007407407

0.006610634

0.0001471

0.011316

-0.01951

4-Mar-08

-0.012396694

-0.012178309

-0.010319917

0.0001444

-0.01794

0.00554

5-Mar-08

0.008368201

0.007908816

0.010522324

0.0001463

0.018075

-0.00971

6-Mar-08

0.01659751

0.005769675

0.00478424

0.0001487

0.008159

0.008439

9-Mar-08

0.085714286

0.011932079

0.013350761

0.0001484

0.022961

0.062753

10-Mar-08

0.086466165

0.009070295

0.008476138

0.0001476

0.014539

0.071928

11-Mar-08

0.107266436

-0.011910112

-0.010140691

0.0001479

-0.01763

0.124896

12-Mar-08

0.04375

0.007732545

0.007291186

0.0001473

0.012491

0.031259

Stock

Index

Accumulation

Correlations

0.64

0.58

St Dev

0.0143

0.0047

0.0048

Beta

1.947234043

1.727916667

(ii)
Assuming that no other information reached the market during this period,
are the results you have obtained consistent with the Efficient Market Hypothesis?
Explain your answer referring to academic research you have studied in this
course. (10 Marks)

Solution:
No the results are not consistent with market efficiency. There is a
significant abnormal return on the day after the announcement of 12.4% and
another of 3.1% two days after the announcement. This suggests the market has
responded very slowly to the release of new information since an investor could
buy the shares on 10 March 2008 and still profit from the 15% abnormal return
over the subsequent two days.

Question 3 (35
marks)

Xentia
Technologies Group (XTG) is considering investing in developing new 4D
television technology. The CEO of XTG, Ms Jane Smith, has appointed you to
evaluate the proposal for the board. If the new project goes ahead it is
expected that it be operational at the beginning of year 2 (with the first
revenues generated by the end of that
year). Once the new project is operational it will render the company’s
existing 2D technology project obsolete. The new project is then expected to
have an operating life of six years.

To
assist you in evaluating the project the following information has been
prepared:

Existing
2D technology project:
Constant
annual earnings before depreciation and taxes (EBDIT) $400,000
Annual
depreciation expense on equipment $0
(Equipment
fully depreciated)
Annual
working capital balance $200,000
Expected
salvage value of equipment if rendered obsolete $0

New
4D technology project:
New
equipment outlays (immediate) $10,000,000
Expected
constant EBDIT $3,800,000
(In
the first year of operation)
Annual
depreciation rate on equipment (straight line) 10%
p.a.
Expected
salvage value of equipment at the end of the project $3,500,000
Working
capital requirement (once project is operational) $300,000

Additional
Information:

Company tax rate is 30%
Xentia is financed with $25 million
in market value of debt and $50 million in market value of equity.
Xentia has a beta of 1.6.
Revolutionary Technology
Corporation (RTC) is currently using technology that is similar in risk
profile to the new 4D project.
RTC is financed with $40 million in
market value of debt and $40 million in market value of equity.
RTC has a beta of 1.75
Xentia borrows debt capital at a
cost of 8% p.a. compounded semi-annually
The long term market risk premium
(including franking credits) is 9.75% p.a.
The current yield on Commonwealth
Bonds is 4.25% p.a.
Xentia operates in an imputation
tax system.

Required:

i)
What is the appropriate
discount rate that should be used to evaluate the project? Explain your decision. (5 marks)

Solution:

Unlevered Beta (RTC)

1.029

Relevered Beta (Xentia)

1.389

Risk Free

0.0425

Return on Market

0.14

Return on Equity

0.17800

Return on Debt

0.08160

Weighted of Debt

0.33

Weight of Equity

0.67

WACC (A/T)

0.10210

ii)
Calculate the NPV of the
project. Present the cashflows used in the NPV calculation in a table. (20 marks)

Solution:

Year

0

1

2

3

4

5

6

7

Equipment Outlay

-$ 10,000,000.00

EBDIT

$
3,800,000.00

$
3,800,000.00

$
3,800,000.00

$
3,800,000.00

$
3,800,000.00

$
3,800,000.00

Depreciation

-$ 1,000,000.00

-$
1,000,000.00

-$
1,000,000.00

-$
1,000,000.00

-$
1,000,000.00

-$
1,000,000.00

Taxable Income

$
2,800,000.00

$
2,800,000.00

$
2,800,000.00

$
2,800,000.00

$
2,800,000.00

$
2,800,000.00

Tax Payable

-$
840,000.00

-$ 840,000.00

-$ 840,000.00

-$
840,000.00

-$
840,000.00

-$
840,000.00

Working Capital

-$
300,000.00

$
300,000.00

Salvage Value

$
3,500,000.00

Tax on Salvage

$
150,000.00

2D EBDIT (A/T)

$
280,000.00

2D EBDIT (A/T) Opportunity Cost

-$
280,000.00

-$ 280,000.00

-$ 280,000.00

-$
280,000.00

-$
280,000.00

-$
280,000.00

2D Recovery of Working Captial

$
200,000.00

Free Cash Flows

-$ 10,000,000.00

$
180,000.00

$
2,680,000.00

$
2,680,000.00

$
2,680,000.00

$
2,680,000.00

$
2,680,000.00

$
6,630,000.00

iii)
Advise whether you should
recommend the project. Explain your decision.

(5
marks)

Solution:

NPV

$2,689,074.46

IRR

16%

Project has a positive NPV and therefore
is acceptable as taking it on will increase shareholder wealth.

Question
4 (20
marks)

Axis Financials Group Ltd (AFG) has performed
well in recent years and financial analyst, Mr Bright-Laad, predicts the
following possible outcomes for the company next year:

State

Probability

Return

Very
Good

0.4

20%

Good

0.3

15%

Average

0.2

10%

Bad

0.1

-5%

i) Calculate the expected return and standard
deviation of returns on AFG Ltd.
(5 marks)

Solution:

State

Probability

Return

Very Good

0.4

20%

Good

0.3

15%

Average

0.2

10%

Bad

0.1

-5%

Expected Return

0.14

Variance

0.0054

Standard Deviation

0.073484692

Two other investments, Titan Property
Management Ltd (TPM) and 10-year Commonwealth Bonds, have been recommended by Mr
Bright-Laad as an option for a three asset portfolio. The expected return and
standard deviation of these securities are given below:

E(Ri)

σ

TPM

15%

8%

Commonwealth
Bonds

10%

0%

The correlation between AFG and TPM = -0.8
The correlation between and AFG and Commonwealth
Bonds = 0
The correlation between TPM and Commonwealth
Bonds = 0

ii) You are considering investing in all three securities
in an equally weighted portfolio. Use the above data to find the expected
return and variance of the portfolio. (10
marks)

Solution:

Portfolio Expected Return

0.1287

Portfolio Variance

0.000260702

Portfolio Standard Deviation

0.016146274

iii) Does
the inclusion of all three stocks (in the portfolio created in part ii) provide
the best outcome for the investor who seeks to minimise their risk? Explain
your answer (no calculations required). (10
marks)

Solution:
No. If any
investor seeks to minimise their risk they should invest 100% in the
Commonwealth Bonds since they have a standard deviation of 0. Note: I’d also accept an answer that
suggests investing in AFG and TPM since this portfolio has a correlation coefficient
of -0.8 (although this would still not yield a standard deviation as low as
100% in Commonwealth Bonds) but would only award a maximum of ½ marks for this
answer.

 

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