FNCE201 Corporate Finance

Question 1A

A company intends to upgrade its machine for a 10-year project, which just passed its sixth year. The new machine is of higher precision which is estimated to reduce defect costs of $80,000 per year and warranty claims by customers by $100,000 per year for the remaining life of the project. The applicable corporate tax rate is 17% and the cost of capital for similar risk projects is 15 percent. More details on the existing and new machines are available:

Required:

i. Compute the incremental net present value of the new machine. (25 marks)

ii. Should the new machine be purchased

Question 1B

Swords Enterprise dividend has been growing at a rate of 25% and it is expected to grow at the same rate for the next two years. After that, Swords Enterprise dividend growth is expected to stay at the rate of 3% perpetually. The company beta is 1.6, the market risk premium is 5%, and the risk-free rate is 3%. It just paid a dividend of $2.00 per share recently.

Required:

i. What is the intrinsic value of Swords Enterprise’s stock based on the dividend discount model? (15 marks)

ii. If the required rate of return on the market portfolio is increased by 2%, what is the required rate of return on Swords Enterprise’s stock?

Question 2A

Discuss three factors, according to Miller & Modigliani (1961) theorem, that impact on firm value arising from the level of dividends that may be paid by a company.(25 marks)

Question 2B

Samantha currently owns a diversified portfolio worth $800,000. She intends to increase her investment by $200,000 and is considering Hill Corporation’s stock. Her financial advisor provided her with some financial information given below. Assume risk free rate of 2% and market risk premium of 5%.

Required:

i.According to the Capital Asset Pricing Model (CAPM), what is the required return on the Hill Corporation’s stock? Would you recommend Samantha to invest in the stock of Hill Corporation? (10 marks)

ii. Calculate the expected return and beta of the new portfolio if Samantha invests in Hill’s stock. Evaluate the risk-return performance of the new portfolio.