Online Assignment: Ratios, Beta, Dividend Model and Business Valuation

Instructions for Online Assignment

1. This Timed Online Assignment contains FIVE (5) questions and comprises SIX (6) pages (including cover page). 
 
2. You must answer ALL questions. 
 
3. If  you  have  any  queries  about  a  question,  or  believe  there  is  an  error  in  the question, while the assignment is in session, briefly explain your understanding of and assumptions about that question before attempting it. 
 
4. Upon  completion  of  your  assignment,  submit  it  online  via  Canvas  (similar  to Tutor Marked Assignment (TMA) submission).  
 5. Your submission is to consist of only one file and of no more than 500MB in size The file must be a Microsoft Word file saved in .docx format. All answers are to be typed. Flowcharts and graphs may be scanned or photographed and embedded in the Word file provided it does not exceed the file size limit of 500MB. Images of text will not be marked. 
 
6. Please submit your answers at the end time of your assignment. Thereafter, you will  not  be  able  to  submit  your  answers  and  you  will  be  considered  as  having  withdrawn from the course. No appeal will be allowed. 
 
7. To  prevent  plagiarism  and  collusion,  your  submission  will  be  reviewed  by Turnitin. The Turnitin report will only be made available to the markers and you will not be able to view it after the submission deadline.
 
The table below shows the ratios for three companies airline, discount clothing store, accounting firm.
Debt-equity 0.2 1.2 0.7 
Inventory Turnover 12.0 0.3 ---- 
Current Ratio 2.5 1.5 1.3 
Sales/Total Assets 4.0 1.7 7.0 
Sales/Receivables 40.0 12.3 7.2 
 
(a) Interpret the ratios in the table to identify the three (3) firms and briefly discuss your reasons using the following format: 
 
(b) Briefly discuss two (2) reasons why it is difficult to use ratios to compare firms from different countries.
 
(c) Briefly  discuss  the  basis  for  Mogdiliani  and  Miller  (MM)  to  claim  in  their Proposition 1 that capital structure does not matter. 
Jack is the manager of a portfolio whose composition is shown below. The market risk premium is 7% and the risk-free rate is 3%. 
 Security Investment Beta 
   
A $5 m 1.2 
B $3 m 1.0 
Treasury Bills $2 m Not given 
 
(a) Calculate the beta and expected return of the portfolio.
(b) Appraise and discuss why Jack included Treasury Bills in the portfolio. 
(c) Jack  strongly  believes  that  the  stock  market  would  fall  in  the  next  one  year Discuss  one  (1)  possible  way  that  he  could  use  to  reduce  the  impact  on  the portfolio if the stock market were to fall.
 
The recent trade war has hit the Orange Company severely. Management announced that previous plans to expand its operations would be cancelled. Orange just paid a dividend of $2.50 but announced that next year’s dividend would be cut to $2 per share, and only grow at a rate of 2% per year forever.  
 
The market price of the stock was $20 before the announcement. The stock’s expected return is 15%. 
 
(a) Calculate  the  price  of  the  stock  after  the  announcement  based  on  the  constant dividend growth model.  
 
(b) Explain one (1) limitation of the constant dividend growth model.
 
(c) Briefly  discuss  two  (2)  reasons  each  for  an  investor  to  prefer  to  invest  in  the convertible bonds of a company over the company’s: 
 
(i) Preferred shares  
(ii) Ordinary shares 
 
DEF Company owns several businesses. The trade wars have caused a general slowdown in business and DEF has decided to downsize. DEF intends to sell its nursery and garden business for $700,000 and has approached XYZ Company as a potential buyer. XYZ is hesitant about purchasing the business as it is not confident about making the business succeed.  To  sweeten  the  deal  DEF  agrees  to  buy  back  the  business  for  $400,000  in  3  years’ time if XYZ wants to give up the business then. 
 
• Cost of nursery and garden business is $700,000 
• No additional working capital is needed 
• Staff costs are $200,000 per year 
• Rental of land is $120,000 per year 
• Projected sales each year is $500,000  
• Variable costs (plants, gardening tools, etc.) are 10% of sales 
• DEF  offers  buy  back  the  business  for  $400,000  after  3  years  if  XYZ  does  not  
want to continue with the business 
  
XYZ intends to fund part of its purchase of the business using borrowing. It also intends to  maintain  a  capital  structure  similar  to  the  typical  nursery  and  gardening  firm  in  the  industry.  
 
Financial information of a typical nursery and gardening firm are:  
Typical beta = 1.5 times of market beta 
Risk-free rate = 3% 
Market risk premium = 6% 
Corporate tax rate = 20% 
Typical debt to equity ratio = 0.5 
Typical WACC = 10% 
  
(a) Calculate ABC’s cost of equity and cost of debt.  
 
(b) Calculate the operating cash flows related to the project.  
 
(c) Calculate the NPV of the project assuming XYZ intends to run the business for three years only. Use a discount rate of 10%.
 
(d) Suppose XYZ intends to run the business forever, solve for the IRR associated with the project.       
 
(e) Interpret your results from parts (c) and (d) and discuss whether XYZ should buy the nursery and gardening business.