Principles of Finance

Question 1 (20 marks)

Assuming you are applying for a finance job that requires a Bachelor of Commerce degree

and your potential employer asks you to respond to two scenarios below.

Required:

Evaluate the above two investment options based on the following criteria and determine

which option would have been better at the beginning of 1976 based on these criteria. Note:

You are expected to justify and show full calculations for each criterion.

a) The value of each investment at the end of 2015, i.e. land and savings account.

b) The rate of growth in the land value over the period 1976-2015, expressed as a

nominal interest rate. Note: The interest was compounded quarterly.

c) The rate of growth in the land value over the period 1976-2015, expressed as an

effective interest rate. Note: The interest was compounded quarterly.

d) The amount of cash that would have been invested in the savings account at the

beginning of 1976 to accumulate the same value as the land value estimated by

the real estate agent at the end of 2015. 

Question 2 (20 marks)

Assume that you are a registered financial adviser. A potential customer, who holds a welldiversified

investment portfolio, is seeking financial advice from you to invest in any or all of

the following companies. All of these companies are included in the Australian Stock

Exchange’s ASX 300 Index

You have also gathered the following information:

 The expected return on the Australian Stock Exchange’s ASX 300 Index is

approximately 9.5% over the coming year.

 The average rate of return on the ASX 300 Index has been higher than that of riskfree

Australian securities by around 3.5%.

Required:

a) Determine the minimum rate of return for each of the above companies, which

would be required by potential investors to invest in each company.

b) Explain whether you would recommend the customer invest in any or all of the above

companies. Assume the customer only has an introductory understanding of finance

principles and theory. Note: You are expected to justify your advice using common

language and understandable terminology

Assume the customer decides to invest $180 000 in a portfolio comprising the above

companies as below:

 Company Alpha $90 000

 Company Beta $63 000

 Company Gamma $27 000

Determine: i) the required rate of return, and ii) beta, for the customer’s portfolio.

d) The customer has also invested in Teta Ltd that has paid annual dividends in past

years. The company’s dividends grow at 7% per annum, which is same as Teta’s

earnings growth level and is expected to continue indefinitely. Teta’s shares are

currently trading at a price of $12.30 each. The customer requires a minimum rate

of return of 15% to keep her investment in the company

Question 3 (20 marks)

Future Diversify Ltd (FDL) considers forming an investment portfolio that comprises shares

issued by Blue Ltd and Green Ltd. The following information relates to these shares.

 

Required:

a) Identify and explain three benefits of diversification, e.g. holding a portfolio

comprising different shares compared to holding any single share.

b) Determine the weightings of Blue Ltd shares and Green Ltd shares in FDL’s

proposed portfolio, which would allow the company to achieve an overall return of

18% for the portfolio?

c) Determine the beta of FDL’s proposed portfolio in Part (b)? 

Question 4 (20 marks)

XYZ Ltd is evaluating Project A and Project B. Either project will last 5 years and will

require a new equipment to be purchased immediately. The company’s tax rate is 30%

and its required rate of return for all investment projects is 10%. Assuming the

company requires a minimum payback period of 2 years for all investment projects.

Other information relevant to Project A and Project B is provided below.

 

Required:

a) Should the company accept Project A or Project B based on: i) payback method,

and ii) net present value (NPV) method? Explain why.

b) Compare the payback method and net present value (NPV) method based on

four criteria below. You are required to refer to Project A and Project B above to

illustrate your response.

1. Does the method correctly rank competing projects?

2. Does the method correctly identify wealth-increasing projects?

3. Does the method recognise the timing of the cash flows and their

relative magnitudes?

4. Can management understand the results?

Question 5 (20 marks)

The Smith’s business manufactures motor vehicle parts. The business is owned and

operated by two brothers whose marginal tax rate is 45% per annum. The brothers are

planning to replace an old manually-operated machine with a new fully-automated machine.

The information regarding the old machine and proposed replacement machine is given in

the table below.

Other information related to the new fully-automated machine includes:

 The maintenance workers would require special training for the new machine.

Fortunately, the required training was provided to the maintenance workers three

months ago when a similar machine was purchased. This training program cost $30

000. However, the company`s management is not sure if they should charge 80% of

this $30 000 training fee against the proposed new machine.

 Since the new machine would work faster than the old one, an additional investment

of $14 000 in raw materials and work-in-process inventories would be required. The

company expects to recover this extra investment at the end of the machine’s

estimated useful life.

 The brothers would have to obtain a loan of $120 000 from the business’ local bank

to purchase the new machine. The loan requires an interest payment at 8% per

annum, which increases the company’s annual interest payments by $8 200 per year.

 The company expects that the new machines will have production capacities similar

to those of the old machine.

 The company’s finance manager has estimated the same 10% per annum after-tax

required rate of return on investments for both old and new machine.

Required:

a) Briefly discuss whether there are any non-incremental cash flows in the scenario. If

so, explain why these costs are regarded as non-incremental.

b) Determine the after-tax initial outlay for the project.

c) Determine the annual after-tax cash flows in Years 1, 2 and 3 for the project.

d) Determine the project’s after-tax terminal cash flow in Year 4.


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