The University of Nottingham

BUSINESS SCHOOL A LEVEL 2 MODULE, AUTUMN SEMESTER 2009-2010 FINANCIAL MANAGEMENT

Suggested Solution Question 1 (i) a. The portfolio beta is the weighted average of the individual security betas. Company GENM KLK BJG HLB DIKI No. of shares 20,000 100,000 50,000 120,000 110,000 Beta 1.3 1.6 1.1 0.8 0.9 Share price (RM) 2.80 10.50 1.20 7.20 5.50 Market Value (RM) x Beta 56,000 1,050,000 60,000 864,000 605,000 2,635,000 Weighted Beta 0.03 0.64 0.03 0.26 0.21 1.16

Since the portfolio beta is 1.16 and it is greater than 1, the portfolio is riskier than the market. b. To advise the company, we need to compare the returns predicted by the CAPM with expected returns. Shares with expected returns less then those predicted by these betas are over priced and should be disposed of. Company GENM KLK BJG HLB DIKI Beta 1.3 1.6 1.1 0.8 0.9 Required rate of return 17.8 20 16.3 14 14.75 Expected return 15 20 18 12 16 Value Overvalued Fairly valued Undervalued Overvalued Undervalued Advice Sell Hold Buy Sell Buy

1 (ii) a. Beta for precious metal fund = [correlation (previous metal fund, National fund) x volatility of precious metal fund ] / volatility of national fund

= 0.5 x 0.3 / 0.25 = b. The required rate of return = = 0.60 5% + 0.6 [ 15 5] 11%

Question 2
(I) We will calculate cash flows as if there were no debt. Earnings Before Taxes (EBT below), is calculated as Revenues-Costs-Depreciation. Net Income=EBT-Taxes=EBT(.66). Cash Flow=Net Income + Depreciation. The following numbers are in millions. Year 1 2 3 4 5 Revenue 5 7.5 9 10 10.5 - Costs 4 5.5 6.2 6.8 7.2 - Writtendown 4 4 4 4 4 allowance/ depreciation EBT -3 -2 - 1.2 - 0.8 - 0.7 1.02 0.68 0.408 0.272 0.238 Taxes/ (rebate) Profit after tax - 1.98 - 1.32 - 0.792 - 0.528 - 0.462 Written allowance/ 4 4 4 4 4 depreciation Cash flow 2.02 2.68 3.208 3.472 3.538 Cash flows will remain at RM3.538 million beyond year 5. Discounting for APV requires an unlevered rate of return on the project, which can be calculated using the project beta (assume that this the asset beta): 1.1*3.8% + 4.5% = 8.68%.

-Then the terminal value at year 5 is 3.538 / .0868 = RM40.76 million. (perpetuity b/c CFs beyond year 5 is the same as year 5CF) -Discounting this terminal value as well as the year 1 through 5 cash flows, and subtracting the initial investment,

NPV

=(2.02/1.0868)+(2.68/1.0868^2)+(3.208/1.0868^3)+(3.472/1.0868^4)

+(3.538/1.0868^5)+(40.76/1.0868^5) Initial

investment (5 D + 15 E)

leads to an NPV of all-equity financed project of RM18.333 million. -The tax shields are RM5 million *.34*.045 = RM76,500 for years 1 through 5 and RM7 million *.34 *.045 = RM107,100 per year beyond year 5. -Discounting the post-year 5 tax shields at the risk-free rate, we get the present value of the perpetuity Interest payment (we are back to ): RM7 mill x 0.34 x 0.045 / 0.045= RM7 million * . 34 = RM2.38 million as a year 5 terminal tax shield value. So discounting a 5 year annuity of 76,500 at 4.5% and adding the present value of RM2.38 million, we obtain RM2.246 million as the present value of all future tax shields. Finally, RM18.333 million + RM2.246 million = RM20.58 million APV

( ii ).

In case 1, interest payments and tax shields are constant over time (except to the extent that default is possible or that the firm may have negative taxable income). In this case, the tax shield is less risky than the project, so it should be discounted at a lower rate. In case 2, debt rises when equity rises, so tax shields are also positively related to equity. Then if equity has positive market risk, so do the tax shields. This case results in a higher discount rate for the tax shields and a lower value.

Question 3

a.

-12.5 + 1.2m (PVIFA12, 12%) = =

-12.5m + 1.2 (6.8109) -RM4,326,963 RM2,483,980

b. -12.5m + 2.2m (6.8109)

c. If they proceed with the project today, the projects expected NPV = (0.4 -RM4,326,963) + (0.6 RM2,483,980) = -RM240,397. So, TH Corporation would not do it. d. Since the projects NPV with the tax is negative, if the tax were imposed the firm would abandon the project. Thus, the decision tree looks like this: 0 12% r= 1 2 0
| |

1,785,714

40% Prob. | | Taxes -12,500,000 12,000,000 No Taxes | 60% Prob. -12.500,000

|

15 0
| |

NPV @ Yr. 0 -RM

2,200,000

2,200,000

2,200,000 2,483,980

Expected NPV RM 776,102 Yes, the existence of the abandonment option changes the expected NPV of the project from negative to positive. Given this option the firm would take on the project because its expected NPV is RM776,102 e. 40% Prob. Taxes 0 = 12% r NPV = ?
|

1 -3,000,000 +600,000 = NPV @ t = 1

|

NPV @ Yr. 0 }wouldnt do RM

0.00

No Taxes 60% Prob. RM1,607,142

NPV = ?

-3,000,000 +6,000,000 = NPV @ t = 1Expected

2,678,571 NPV

If the firm pays RM1,607,142 for the option to purchase the land, then the NPV of the project is exactly equal to zero. So the firm would not pay any more than this for the option.