Business Accounting and Finance - Assignment Example

Instructions 1. This assignment contains SIX Questions. You should provide answers for ALL of the questions in the space provided for each question. 2. Your answers for this assignment are to be type written. You can expand the space in the areas provided for your answers as needed. 3. Read the Assignment Instructions that can be accessed from the Course Outline. 4. Marks will not be given for any calculation type of questions without showing full calculations. 5. Ensure you keep a copy, and insert your name, student ID number and page numbers in the footer of this document before saving and submitting this file via Gradebook on the learnonline course website. 6. You must submit this file containing your completed Assignment Cover Sheet and assignment answers via Gradebook in ONE SINGLE DOCUMENT. 7. It is important that you document how you arrived at your answer, particularly detailing calculator key strokes used for your calculations. For some problems it is beneficial to draw a time line to identify the amount and timing of cash flows. 8. Most of the marks for each question will be given for the process used to arrive at your answer. Therefore, if you just provide an answer that is wrong and there are no supporting details as to how you arrived at that answer, you won’t get any marks. But if you have detailed your process (which may have been correct but you made some error with your calculations) then you have the opportunity to get some marks for the question. 9. Ignore inflation in your answers and where possible interest rates should be calculated as percentages to 4 decimal places (e.g. 1.2678%). 10. You must ensure that your assignment answers are your own work. The Academic Integrity section of the Course Outline Booklet details the various University policies that will apply to academic misconduct. 11. Ensure that you have properly acknowledged the work of others that enabled you to complete your assignment. A finance assignment that mostly comprises calculations is no different from a written (e.g. essay) assignment. You must acknowledge by a reference and/or bibliography all texts and sources that provided you with the formulae etc. to do your calculations. Question 1 [15 mars] (a) You want to travel to Europe to visit relatives when you graduate three years from now. The trip is expected to cost a total of $10,000 at that time. Your parents have deposited $5,000 for you in an account paying 6% interest annually, maturing three years from now. Aunt Hilda has agreed to finance the balance. If you are going to put Aunt Hilda's gift in an investment earning 10% over the next three years, how much must she deposit now, so you can visit your relatives at the end of three years? (6 marks)  Interest = p * i * n Aunt Hilda’s contribution=10000-5900=4100 5000*6/100*3=900 P = A / (1 + rt) Total amount=5000+900=5900 P=4100/(1+10*3) Paid by parents=5900 P= 3,153.85 (b) As a part of your savings plan at work, you have been depositing $250 per quarter in a savings account earning 8% per annum interest, compounded quarterly, for the last ten years. You will retire in 15 years and want to increase your contribution each year from $1,000 to $2,000 per year, by increasing your contribution every three months from $250 to $500. Additionally, you have just inherited $10,000 which you plan to invest now to earn interest at 12% compounded annually for the next 15 years. How much money will you have in savings when you retire 15 years from now? Draw appropriate timeline(s) to demonstrate your calculations. (9 marks) Start answer Question 1 12/3=4 Quarters per year Rate =8% per annum A=10000(1+12/100)15 Rate per quarter= 8/4=2% A=54735.66-inheritance 10 years=40 Quarters Total savings=54735.66+4416.08 1st quarter=500 A=2000(1+8/100)40 =59151.74/= 2nd=1000 3rd=1500 4th=2000 =4416.08 Question 2 [13 marks] (a) The market index experienced the following returns over the first 6 months of this year: Month Return Month Return January 0.68 April -1.71 February 5.43 May -2.44 March 1.12 June 3.58 What is the average return and standard deviation of returns over this six-month period? (6 marks) Mean=(0.68+5.43+1.12+-1.71+-2.44+3.58)/6=1.11 average return Deviation=(0.68-1.11)=-0.43 =1.12-1.11=0.01 =-2.44-1.11=1.33 =5.43-1.11=4.32 =-1.71-1.11=-2.82 =3.58-1.11=2.47 Deviation squared=34.6696/6 vAriance=5.778 SD=2.403 (b) Security A has an expected rate of return of 25 percent and a beta of 2.5. Security B has a beta of 1.20. If the Treasury note rate is 8 percent, what is the expected rate of return for Security B? (4 marks) 2.5*(0.25-0.08)=1.20(X-0.08) 0.3542+0.08=X 0.425/1.20=X-0.08 X=0.434 X=43.42% (c) What are the two components of a security’s risk? What can an investor do about them (answer is limited within 200 words)? (3 marks) Start answer Question 2 Investors in their choice of investments faces several risks which is broadly classified as; 1. Systematic risk 2. Unsystematic risk. Unsystematic risk also known as diversifiable risk are risks which is specific to an individual firm. This kind of risk can be eliminated through diversification. Examples risks, which can be specific to a firm or industry, is regulatory authorities, lawsuits, loss of market. On the other hand, Systematic risk affect the entire market and an individual firm cannot avoid. This kind of risks includes changes in taxation policies, changes in the world market, foreign investment policy changes as well as range issues that affect the entire market. Unsystematic can be mitigated through product or market diversification unlike systematic risk which an individual firm has no control. Finish answer Question 3 [30 marks] SingTel Ltd. is an Australian operated company with mainly Singaporean resident shareholders. The company is currently in the process of comparing two mutually exclusive machines for use in a new project with Machine A costing $30,000, having a useful life of five years and machine B costing $45,000 and having a useful life of 10 years. Cash inflows from sales are expected to be $22,000 p.a. from each machine, while total cash-based operating costs are expected to be $10,000 and $8,000 respectively for each machine. All revenues and costs are assumed to occur at the end of the respective years for simplicity of assessment. Machine A is expected to have a salvage value of $4,000 at the end of 5 years, while at the end of 10 years machine B will be worthless. Depreciation for accounting and tax purposes is calculated on a straight-line basis on the original cost of each machine with no consideration in depreciation calculations for any expected salvage value. The company has an after-tax required rate of return of 14% and pays income tax at the rate of 40% in the year following the year of income (that is, taxes levied on year 1 income are paid at the end of year 2). Required : a) Provide some reasons as to why the alternative machines are said to be mutually exclusive for the company. (3 marks) Two machines are said to be mutually exclusive because the work done by one is a replica of work done by the other. Therefore, if the company has acquired one of the machines there is no need for the other machine since the work available is enough only for one machine. b) Record the relevant cash-flows for each machine on a time (cash-flow) diagram. (7 marks) Year Machine A Machine B Initial Outlay 30000 45000 Cash in flows 110000 110000 Operating expenses -10000 -8000 Depreciation 6000 4500 Salvage value 4000 0 68000 60500 After tax 14 Percent (9520) (8470) Add back depreciation 6000 4500 Total 58480 56530 c) Advise the company which machine (if any), should be purchased and justify all the processes you have used in order to reach your decision. (15 marks) MACHINE A Year Amount PVIF% Total 0 (30000) - 1 22000 0.8772 19298.40 2 22000 0.7695 16929 3 22000 0.6750 14850 4 22000 0.5921 13026.20 5 22000 0.5194 11426.80 Toatal 75530.4 MACHINE B Year Amount PVIF% Total 0 (45000) - 45000 1 22000 0.8772 19298.40 2 22000 0.7695 16929 3 22000 0.6750 14850 4 22000 0.5921 13026.20 5 22000 0.5194 11426.80 6 22000 0.4556 10023.20 7 22000 0.3996 8791.20 8 22000 0.3506 7713.20 9 22000 0.3075 6765 10 22000 0.2697 5933.40 Total 159756.4 Equivalent Annual Cost =75530.4/3.4331=22000.64-project A Equivalent Annual cost =159756.40/5.2161=30627.56 Machine B Machine A should be purchased since it has lower equivalent annual cost compared to B even though B has higher NPV. d) (i) Why is NPV considered to be the best method for capital budgeting? What does the NPV tell you? NPV is considered superior than other capital budgeting appraisal methods because it takes into consideration time value of money. Also it takes into consideration the relevant expected cash flows .Finally, it takes into consideration the impact of decisions arrived on shareholder wealth maximisation. (ii) When evaluating two mutually exclusive rojects with unequal lives, is the project with the higher NPV better? Why or why not? (5 marks) (Answer is limited within 600 words for this question) A project with higher NPV will be accepted however, the best method of appraising two mutually exclusive projects with unequal lives is using annual equivalent NPV. The project with least equivalent annual cost is chosen. Start answer Question 3 Finish answer Question 4 [16 marks] (Source: Petty, J.W. et al 2012, Financial Management: Principles and Applications, 6th Edition, Pearson Australia, Frenchs Forest, NSW. P. 353) You have a substantial amount of money invested in three different unlisted financial securities. As these investments are not traded on the financial markets, they do not have an observable market price but you have ascertained the following information: Company bonds: $1,000 face (par) value with 6 years to maturity, paying 11% p.a. semi-annual coupons. Currently the yield on 6-year government bonds is 6% p.a. and you think that a risk premium of 4% p.a. is appropriate for these company bonds. Preference shares: Irredeemable, paying 8% annually on $10 par value, and your estimate of the risk premium for these shares is 7% p.a. Ordinary shares: Five years ago the annual dividend paid by the company was 12 cents per share and given this year’s dividend of 18.5 cents per share you expect future dividends to grow at the same annual compound rate. From your analysis of the variability of the company’s earnings over the last five years, you deem a reasonable estimate of the company’s market risk (beta) to be 1.7. Also, you know that the long-term historical average return from a market portfolio investment is 13% p.a. On the basis of this information, estimate the current value of each security. Start answer Question 4 Company bonds=1000(1+0.11)12-1000(1+0.04)6 =3498.45-1265.32=2233.13 Preference Shares=10(1+0.08)-10(1+0.07) =10.8-10.7 =0.1 Ordinary Shares=18.5-12=6.5 =6.5/12*100 =54.17%-13%=41.17/100*1.7 =0.699 Finish answer Question 5 [16 marks] You are considering two mutually exclusive projects. The expected values for each project's end-of-year cash flows are: Year Project A Project B 0 -$1,000,000 -$1,000,000 1 550,000 500,000 2 700,000 680,000 3 600,000 700,000 4 500,000 800,000 You have decided to evaluate these projects using the certainty equivalent method. The certainty equivalent coefficients for each project's cash flows are given below: Year Project A Project B 0 1.00 1.00 1 0.95 0.90 2 0.85 0.70 3 0.80 0.60 4 0.75 0.55 Required : a) Given that the required rate of return is 8.5% p.a. and risk-free rate of return is 6% p.a., what is the NPV of each project? (10 marks) Year Project A Co-efficients Total Project B Co-efficients Total 0 -1,000,000 1 -1000000 -1,000,000 1 -1000000 1 550,000 0.95 522500 500,000 0.90 450000 2 700,000 0.85 595000 680,000 0.70 476000 3 600,000 0.80 480,000 700,000 0.60 420000 4 500,000 0.75 375000 800,000 0.55 440000 972500 786000 NPV PROJECT A=972,500 NPV PROJECT B= 786,000 b) Briefly discuss and justify which project, if any, should be preferred. (3 marks) Project A would be preferred over project B since it has higher NPV though for both projects the required rate of return is more than risk free rate of return. c) In practice, what factors are likely to influence the selection of the certainty equivalent coefficients for each project's expected cash flows? (3 marks) (Write no more than 300 words for this question) The certainty equivalent is arrived by investor bearing in mind the prevailing circumstances in the economy and period, which an investment will cover. The longer the period the lower the certainty equivalent since the perception by the investor is it many variables that constitute risk abound with an investment that runs for longer period. The risks include depreciation, change in technology, and change in market conditions as well political upheavals, which may displace a population. All these factors render the market volatile and any manager must incorporate such factors when making capital budgeting decisions. Start answer Question 5 Finish answer Question 6 [10 marks] a) If the nominal rate of interest is 11.5% p.a. and the anticipated rate of inflation is 2.2% p.a., what is the real rate of interest to the nearest 0.1% ? (2 marks) 11.5%-2.2 %=9.3% b) Explain in your own words to an inexperienced investor, your interpretation of a real rate of interest. (3 marks) Real rate of interest is the actual interest rate after the prevailing inflation rate has been factored in. In other words, it is the interest rate an investor expects after removing inflation rate. (c) Outline how the agency problem can interfere with the implementation of the goal of shareholder wealth maximisation. (5 marks) Conflict of interest arise where managers perceive that their hard work may not trickle down to them. In addition, managers may reward themselves with huge salaries hance eroding the shareholder dividends. Managers may also invest in projects that aims at improving their image at the expense of profitability. Managers can also threaten to turn the company into private company by buying majority shares. Managers can also spend a lot of time in non-business activities instead of engaging in business. Also managers may engage in projects that are highly risky but yielding high profits. (Write no more than 200 words for both part (b) and (c) of this Question). Start answer Question 6 Finish answer REFERENCE: 1. Khan, M.Y. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education 2. Gowthorpe C.(2005) Business Accounting and Finance, London. Pat Bond 2ND Ed. Read More