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Question:
Each of the following question worth 10 marks, please answer all of them. If needed please use Harvard referencing style. There is no word limit, but it is necessary that you provide answers with explanations.
Question 1:
  1. Assume that you will deposit $4000 at the end of each of the next three years in a St. Georgebank account paying 8% interest. You currently have $7000 in the account. How much will you have in three years? In four years?
  2. You are looking into an investment that will pay you $12,000 per year for the next 10 years. If you require a 15% return, what is the most you would pay for this investment?
  3. A bond has an 8% coupon, paid semi-annually. The face value is $100, and the bond matures in 6 years. If the bond currently sells for $91.137, what is the yield to maturity? What is the effective annual yield?
Question 2:

We have two investment projects A&B. Both projects cost $250, and we require a 15% return of the two investments.

1   $100 $100      

2  $100 $200

3  $100 0

4  $100 0

  1. Based on the payback period rule, which project would you pick? Explain.
  2. Based on the NPV rule, which project would you pick? Explain.
  3. Do a) and b) give you the same conclusion? If not, why? Please
  4. What other methods can you use to evaluateproposed investments? Please explain.
Question 3:

The ABC Company has a WACC of 20%. Its cost of debt is 12%, which is equal to the risk-free rate of interest. If ABC’s debt to equity ratio is 2, what is the cost of equity capital? ABC’s equity beta is 1.5.

  1. What are the M&M propositionsI, II and III, please use graphs/charts and words to explain.
  2. Based on the M&M proposition II, what is the beta of the entire firm?
Answer:

Que 1:

Task 1.1 Calculation of future value

 

 

 

 

 

 

Deposit amount

 $                          4,000

 

 

Interest rate

8%

 

 

Current amount

 $                          7,000

 

 

 

 

 

 

 

 

 

 

Calculation of $ 7000 after 3 and 4 years

 

 

 After 3 years

After 4 years

 

Formula

Fv = contribution * (1+rate)^ number of years

 

 

7000*(1+8%)^3

7000*(1+8%)^4

 

Amount

 $                          8,818

 $   9,523.42

 

 

 

 

 

Calculation of $ 4000 investment each year after 3 and 4 years

 

 

 After 3 years

After 4 years

 

Formula

Fv = contribution/ rate *((1+rate)^number of years)-1)

 

 

(4000/8%)*(((1+8%)^3)-1)

(4000/8%)*(((1+8%)^4)-1)

 

 

 $                        12,986

 $      18,024

 

 

 

 

 

Calculation of total amount

 

 

 After 3 years

After 4 years

 

4000 investment

 $                        12,986

 $      18,024

 

Current amount

 $                          8,818

 $        9,523

 

 

 $                        21,804

 $      27,548

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Task 1.2 Calculation of present value

 

 

 

 

 

 

Payment (each year)

 $                        12,000

 

 

Time (years)

10

 

 

Interest rate

15%

 

 

 

 

 

 

Calculation of present value

 

 

 

 

 

 

Formula (PV) =

C / r ? ( 1 – 1/(1+r)N ) ? (1+r)

 

 

 

(12000/0.15)*(1-(1/(1+0.15)^10))*(1+0.15)

 

 

 

 $                   69,259.01

 

 

 

 

 

 

 

 

 

 

 

 

 

Task 1.2 Calculation of present value

 

 

 

 

 

 

Coupon rate (semi annually)

8%

 

 

Face value

 $                        100.00

 

 

Time (years)

6

 

 

Selling price

 $                          91.14

 

 

 

 

 

 

Calculation of effective annual rate (EAR)

 

 

 

 

 

 

Formula (EAR)=

((1+periodic rate)^number of periods in a years)-1

 

 

 

((1+8%/2)^(2-1)

 

 

 

8.2%

 

 

 

 

 

 

Calculation of yield to maturity (YTM)

 

 

 

 

 

 

Coupon rate (semi annually)

4%

 

 

Face value

 $                        100.00

 

 

Time (years)

12

 

 

Selling price

-$                         91.14

 

 

PMT (coupon rate * face value)/2

 $                            2.00

 

 

 

 

 

 

YTM = C / y ? ( 1 – 1/(1+y)N ) + Face / (1+y)N

2.88%

 

 

 

 

(Titman  and Martin, 2014)

Que 2:

Task 2.1 Calculation of Payback period

 

 

 

 

 

 

 

 

Payback period (Project A)

 

 

 

 

 

 

Time

Cash Flow

Cash inflow

Cumulative Cash Flow

 

 

Amount in $

 

Amount in $

 

0

-$ 250.00

 

-250

 

1

 

 $ 100.00

-150

 

2

 

 $ 100.00

-50

 

3

 

 $ 100.00

50

 

4

 

 $ 100.00

150

 

Payback Period

 

 

2.50

 

Payback period (Project B)

 

 

 

 

Time

Cash Flow

Cash inflow

Cumulative Cash Flow

 

Amount in $

 

Amount in $

0

-$ 250.00

 

-250

1

 

 $ 100.00

-150

2

 

 $ 200.00

50

3

 

 $         -   

 

4

 

 $         -   

 

Payback Period

 

 

1.75

 

It explains that the project B must be accepted by the business due to lower payback period.

(Madhura, 2011)

Task 2.2 Calculation of Net present value

 

 

 

 

 

 

 

 

 

 

Net present value (Project A)

 

 

 

 

 

 

 

Time

Cash Flow

Cash inflow

P.V. factor

P.V.

 

0

-$ 250.00

 

1.00

-250

 

1

 

 $ 100.00

0.87

86.96

 

2

 

 $ 100.00

0.76

75.61

 

3

 

 $ 100.00

0.66

65.75

 

4

 

 $ 100.00

0.57

57.18

 

Net present value

 

 

 

35.50

 

Net present value (Project B)

 

 

 

 

 

Time

Cash Flow

Cash inflow

P.V. factor

P.V.

0

-$ 250.00

 

1.00

-250

1

 

 $ 100.00

0.87

86.96

2

 

 $ 200.00

0.76

151.23

3

 

 

 

 

4

 

 

 

 

Net present value

 

 

 

-11.81

 

It explains that the project A must be accepted by the business due to lower positive and higher net present value.

The calculations of 2.1 and 2.2 explain that according to the payback period calculations, project B must be accepted while in case of net present value, project A must be accepted. The different among both the results are due to the different concept of both the methods. NPV focuses on the profitability level whereas payback period evaluates that in how much time project would return the invested amount. On the basis of the overall calculations, it has been measured that Project A must be accepted by the business as the return from project B is negative.

Task 2.4 Calculation of PI

There are various other capitals budgeting method which could also be applied in this case to measure that which project is better for the purpose of investment in terms of profits, return, payback time etc. In this case, profitability index, IRR, accounting rate of return etc methods could also be applied to measure the overall position of the company.

The profitability index of the case also suggests that project A is better choice for the purpose of the investment.

Profitability Index (project A)

 

 

 

 

 

Time

Cash Flow

Cash inflow

P.V. factor

P.V.

0

-$ 250.00

 

1.00

-250

1

 

 $ 100.00

0.87

86.96

2

 

 $ 100.00

0.76

75.61

3

 

 $ 100.00

0.66

65.75

4

 

 $ 100.00

0.57

57.18

Profitability index

 

 

 

2.84%

 

Profitability Index (Project B)

 

 

 

 

 

Time

Cash Flow

Cash inflow

P.V. factor

P.V.

0

-$ 250.00

 

1.00

-250

1

 

 $ 100.00

0.87

86.96

2

 

 $ 200.00

0.76

151.23

3

 

 $         -   

0.66

0.00

4

 

 $         -   

0.57

0.00

Profitability index

 

 

 

-0.95%

Que 3:

Task 3.1 M&M propositions

The case explains that the performance of ABC Company is as follows:

WACC

20%

Cost of debt

12%

Risk free rate

12%

Debt to equity ratio

2

Beta

1.5

Cost of equity

?

The M&M proportion 1 explains that the capital structure is not a measurement tool to evaluate the value of a business. Such as two companies which are operating in the same industry with the same assets can be different in the value. The main different thing among those 2 companies is the liabilities and the equity level of the business. In case of ABC limited, value of the company is 2:1 of debt and equity which can be understood through the below chart:

Figure 1: M&M proposition 1

The M&M proposition 2 mainly focuses on the cost of equity of the business. It explains that the changes into the capital structure and the market factors directly affect the cost of equity of the business (Brown, 2012). The cost of equity of ABC limited and the proposition graph are as follows:

Re = Ra + (Ra - Rd) x (D/E)

12%+(12%-12%)*2

 

12.00%

 

Figure 2: M&M proposition 2

The M&M proposition 3 mainly focuses on the overall cost of capital of the business. It explains that the changes into the capital structure, cost of equity, cost of debt etc directly affect the cost of capital of the business (Gibson, 2011). The proposition graph of ABC limited is as follows:

Figure 3: M&M proposition 3

Task 3.2 M&M propositions

On the basis of the evaluation and M&M proposition 2, it has been measured that the beta of the firm is 1.5 and the cost of equity of the business is 12%.

Re = Ra + (Ra - Rd) x (D/E)

12%+(12%-12%)*2

 

12.00%

 

(Brigham and Ehrhardt, 2013)

References:

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory and practice. Cengage Learning.

Brown, R., 2012. Analysis of investments and management of portfolios. Pearson Higher Ed.

Gibson, C.H., 2011. Financial reporting and analysis. South-Western Cengage Learning.

Madura, J., 2011. International financial management. Cengage Learning.

Titman, S. and Martin, J.D., 2014. Valuation. Pearson Higher Ed.

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