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BANK2007 Business Finance

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Question:

Background:

Your client, for whom you are writing the report, is a school teacher by profession. She has two children aged under five, with a steady income. Her knowledge of financial theory and financial mathematics is now at an intermediate level. She (and her partner) is in a position to invest into sound investments for both short-term and long-term returns. She has done some research and has found a number of investments that she wishes to have analysed. As such, you do not have to search for viable investments for her.

You also note that she wishes to invest into securities for retirement, with only the viability of the investment being considered in this report.

While we can garner a degree of information to the clients financial position, we still do not know her (and her partner’s) financial position. In the same manner as the previous report you presented to them, it is impossible to know how many of these investments they can purchase / invest. Therefore you are expected to provide advice on each investment in isolation from the other investments, i.e. not as a portfolio of investments.

Client’s Financial Questions:

  • Provide a brief discussion of approximately 300 words detailing the risks inherent in stock returns in a portfolio of shares using the concepts of standard deviation and diversification as a basis for your
  • Under what conditions can a firm’s weighted average cost of capital be used for assessing newprojects?
  • In the context of the net present value (NPV) modeldiscuss:
  • The conditions that must be observed such that a project that has a positive NPV should be chosen. Why, in these circumstances, would a project that has a positive NPV bechosen?
  • Why depreciation does not involve a flow of cash and therefore can be
  • Within the standard present-value model, why tax savings on interest payments are excluded from the cash-flow
  • The effect of sunk costs within the analysis of a project’s

Client’s Investments:

  1. Lloyds Ltd., is a publicly listed Australian company that your client is following closely, however your client does not have the requisite skills to evaluate the company and, as such has provided you with sufficient information. The historical price of Lloyds Ltd. is given below. Lloyds Ltd. is closely integrated with the Australian economy and so the rates of return for the Australian economy as a whole can be used in the evaluation process.

You know that Australian Treasury bills currently pay a return of 4% p.a., the stock market return over the same period averaged 10% p.a., and have calculated the standard deviation of the market returns to be 12% p.a. Lloyds Ltd. beta is estimated at 1.40. Lastly, you have identified the historical returns and dividends (below).

Year

Price

Dividend

2009

$3.60

 

2010

$3.25

$0.30

2011

$3.65

 

2012

$4.50

$0.35

2013

$4.45

 

2014

$4.68

$0.45

2015

$5.21

 

2016

$6.01

$0.50


Using the above information, identify whether it is a good idea, for your client, to invest in Lloyds. Explain your reasoning for your decision.

  1. RunRig Ltd. is an investment company with the following balancesheet:

Long-term debt

$

Bonds: Par $100, annual coupon 10% p.a., 5 years to maturity

3,000,000

Equity

 

Preference shares

1,000,000

Ordinary shares

1,000,000

Total

5,000,000

Notes:

The company’s bank has advised that the interest rate on any new debt finance provided for the projects would be 9% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate.

There are currently 100,000 preference shares on issue, which pay a dividend of $1.20 per year. The preference shares currently sell for $8.65.

The company’s existing 500,000 ordinary shares currently sell for $2.95 each. You have identified that RunRig has recently paid a $0.25 dividend. Historically, dividends have increased at an annual rate of 4% p.a. and are expected to continue to do so in the future.

The company’s tax rate is 30%.

Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to RunRig would be 11% p.a.

Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing).

  1. What are the assumptions underlying the use of a dividend growth model for the estimation of a company’s cost ofequity?
  1. Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital
  1. Calculate the after-tax costs of capital for each source of
  1. Determine the after-tax weighted average cost of capital for the company.
  1. Your client is investigating two start-up companies that operate in the same telecommunications sector in Australia. These two companies are investigating similar projects (not both) in which they will invest. However, your client is not sure which is better and has sent the relevant details to you for advice. The characteristics of the two systems are given below:

 

Project 1

Project 2

Initial Outlay (IO)

$13,000,000

$18,000,000

Annual Cash Flows (CF)

$3,500,000

$6,000,000

Life of system

8 years

5 years


Notes: 1) All cash flows are after tax and depreciation.

2) A flat rate of 14% is estimated as the risk in both of these projects.

Your client wishes you to provide detailed calculations indicating which system you believe to be the best. The client will then decide whether to invest into the company looking to invest in the project.

 
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