ACC00716 Finance | Corporate Financial Accounting

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Question 1

Collect the company’s 5 year growth rate (CAGR) in operating revenue as at the end of the most recent financial year. (If the company has not been listed that long, use the 1 or 3 year rate – whichever is longer – as a proxy.) If this CAGR can be expected to continue, what is your prediction for operating revenue for the 2020/21 financial year?

Question 2

Collect the company’s interest expense from the profit and loss statement for the year ending 30 June 2016 and divide this figure by average long-term debt in the balance sheet for the last two financial years. Use this as a very rough approximation of the quoted annual interest rate that the company would have to pay on new long-term debt. Now hypothetically assume that on 1 July 2016, the company took out a 20 year amortised loan of $800,000 to buy some equipment and that the rate of interest on that loan is fixed for the first 4 years at the rate you calculated above. The loan requires monthly payments, due on the last day of the month. How much interest will the company be able to claim as an annual tax deduction in the first financial year (1 July 2016 to 30 June 2017) and in the fourth financial year?

Question 3

Assume that the company has just received a large amount of cash from selling assets and wants to use this cash to repay $2 million in debt maturing in three years. In the meantime, the necessary cash can be invested into one of the following investments:

(1) A fund with a quoted fixed rate of 4.20% compounded semi-annually;

(2) A fund with a quoted fixed rate of 4.14% compounded monthly; or

(3) Zero coupon bonds maturing in three years and currently trading at $88.45 per $100 face value. Which investment fund should be chosen: 1, 2 or 3? (Assume the investments have equivalent risk.) How much cash will be invested?

Question 4

Hypothetically assume that on 27 January 2017 the company issued 10 year, semi-annual fixed coupon bonds at par, which are given a BB rating and have a spread of 325 basis points over the yield on an Australian government bond of equivalent maturity.

a) What is the yield on the company’s bonds?

b) How would the yield have been different if the company’s bonds had been shorter term? Explain with reference to data and to the relevant component(s) of market interest rates.

c) You have a pessimistic outlook for the Australian economy over the next year. Given this, what do you predict will happen to the spread on the company’s bonds over the next year and why? Ensure you mention the relevant component(s) of market interest rates in your answer.

d) What do you expect to happen to the price of the company’s 10 year bonds if your prediction in part c is correct? Illustrate your answer with a numerical example.

Question 5

a) Use CAPM to estimate the required return on the company’s shares as at 30 June 2015. To do this, use the yield to maturity on that date of a 10-year

Australian Treasury bond as a proxy for the risk-free rate, assume the market risk premium is 6.80% and use the company’s current beta (thus assuming the beta has not changed since mid-2015).

b) Assuming the market risk premium and beta has not changed from 5a), recalculate the required return on the company’s shares as at 30 June 2016. What has happened to the required return and why? In the absence of any other change, what does theory predict should have happened to share prices?

c) Explain would happen to the company’s required return if average risk aversion in the market fell.

Question 6

Collect and evaluate the company’s FCF and ROIC for the two financial years ending 30 June 2015 and 30 June 2016. Assume that the company’s cost of capital (WACC) was the same as the required returns (costs of equity) you calculated in Question 5.

Answers:

Question 1

The value of the revenues for the financial year 2011 and 2016 are as highlighted below (Morningstar, 2017).

Operating revenue in financial year

Company’s five year growth rate (CAGR) can be computed as

5 year CAGR

= per annum

Therefore, the five year growth rate is 5.97% per annum.

Case: If this CAGR would be expected to continue then the operating revenue for the financial year 2020/21 can be computed as (Ross, Trayler and Bird, 2007).

Operating revenue FY2021 =

Question 2

Interest expense for financial year 2016 =

Long term borrowings for FY2016 = $109,736,000

Long term borrowings for FY2015 = $139,461,000

Average long term borrowings =

Applicable interest rate would be =

= per annum

Amortized loan amount

Time period

Interest rate

Monthly instalment can be computed as

Repayment schedule for 480 months (4 years) are computed in the excel spreadsheet and shown below:

Date	Starting principal	EMI	Interest	Principal Repayment	Outstanding principal
Jul-16	800000	4476.9	2066.7	2410.2	797589.8
Aug-16	797589.8	4476.9	2060.4	2416.5	795173.3
Sep-16	795173.3	4476.9	2054.2	2422.7	792750.6
Oct-16	792750.6	4476.9	2047.9	2429.0	790321.6
Nov-16	790321.6	4476.9	2041.7	2435.2	787886.4
Dec-16	787886.4	4476.9	2035.4	2441.5	785444.9
Jan-17	785444.9	4476.9	2029.1	2447.8	782997.0
Feb-17	782997.0	4476.9	2022.7	2454.2	780542.9
Mar-17	780542.9	4476.9	2016.4	2460.5	778082.4
Apr-17	778082.4	4476.9	2010.0	2466.9	775615.5
May-17	775615.5	4476.9	2003.7	2473.2	773142.3
Jun-17	773142.3	4476.9	1997.3	2479.6	770662.7
Jul-17	770662.7	4476.9	1990.9	2486.0	768176.7
Aug-17	768176.7	4476.9	1984.5	2492.4	765684.2
Sep-17	765684.2	4476.9	1978.0	2498.9	763185.3
Oct-17	763185.3	4476.9	1971.6	2505.3	760680.0
Nov-17	760680.0	4476.9	1965.1	2511.8	758168.2
Dec-17	758168.2	4476.9	1958.6	2518.3	755649.9
Jan-18	755649.9	4476.9	1952.1	2524.8	753125.1
Feb-18	753125.1	4476.9	1945.6	2531.3	750593.8
Mar-18	750593.8	4476.9	1939.0	2537.9	748055.9
Apr-18	748055.9	4476.9	1932.5	2544.4	745511.5
May-18	745511.5	4476.9	1925.9	2551.0	742960.5
Jun-18	742960.5	4476.9	1919.3	2557.6	740402.9
Jul-18	740402.9	4476.9	1912.7	2564.2	737838.7
Aug-18	737838.7	4476.9	1906.1	2570.8	735267.9
Sep-18	735267.9	4476.9	1899.4	2577.5	732690.4
Oct-18	732690.4	4476.9	1892.8	2584.1	730106.3
Nov-18	730106.3	4476.9	1886.1	2590.8	727515.5
Dec-18	727515.5	4476.9	1879.4	2597.5	724918.0
Jan-19	724918.0	4476.9	1872.7	2604.2	722313.8
Feb-19	722313.8	4476.9	1866.0	2610.9	719702.9
Mar-19	719702.9	4476.9	1859.2	2617.7	717085.3
Apr-19	717085.3	4476.9	1852.5	2624.4	714460.8
May-19	714460.8	4476.9	1845.7	2631.2	711829.6
Jun-19	711829.6	4476.9	1838.9	2638.0	709191.6
Jul-19	709191.6	4476.9	1832.1	2644.8	706546.8
Aug-19	706546.8	4476.9	1825.2	2651.7	703895.1
Sep-19	703895.1	4476.9	1818.4	2658.5	701236.6
Oct-19	701236.6	4476.9	1811.5	2665.4	698571.3
Nov-19	698571.3	4476.9	1804.6	2672.3	695899.0
Dec-19	695899.0	4476.9	1797.7	2679.2	693219.8
Jan-20	693219.8	4476.9	1790.8	2686.1	690533.8
Feb-20	690533.8	4476.9	1783.9	2693.0	687840.7
Mar-20	687840.7	4476.9	1776.9	2700.0	685140.8
Apr-20	685140.8	4476.9	1769.9	2707.0	682433.8
May-20	682433.8	4476.9	1763.0	2713.9	679719.9
Jun-20	679719.9	4476.9	1755.9	2721.0	676998.9

Interest paid in the 1st year would be the sum of all the interest paid during the time

(July 2016 - June 2017)

Interest paid in 4^th year would be the sum of all the interest paid during the time

(July 2019 - June 2020)

Therefore, the company would be able to claim on the interest amount of as an annual tax deduction in FY2017 and FY2020 respectively.

Question 3

The three investment fund choices are highlighted below:

Investment choice1: Fixed interest rate compounded semi-annually.

Effective annual rate (EAR) can be computed as highlighted below (Ross, Trayler and Bird, 2007).

Where,

= Interest rate (%)

Number of compounding period per year

Investment choice 2: Fixed interest rate compounded monthly.

Effective annual rate (EAR) can be computed as highlighted below:

Investment choice 3: Zero coupon bonds with maturity period of 3 years.

Face value of bond

This would be recovered at the end of the 3^rd year.

Current value of the bond

Annual returns can be calculated as

It can be concluded based on the above analysis that the maximum returns can be obtained from the first investment choice. Therefore, it would be the economically profitable to select the first investment fund choice (Damodaran, 2010).

Let is the amount of cash that would be invested.

The amount received after the three years

Therefore,

Therefore, the company should invest $cash in order to receive an amount of $2,000,000 after three year.

Question 4

The company has issued a 10 year semi-annually fixed coupon bonds at par. BB rating is extended with a spread of 325 basis points over the yield on an Australian government bond of equivalent maturity.

On January 27, 2007 the yield on a 10 year bond is 2.797% per annum (RBA, 2017).

Therefore, the yield on the bond can be computed as

=Risk free rate + Risk premium

Maturity risk premium is considered an imperative element of the interest rate. The value of the yield is greater for the bonds which are issued with a high maturity period as the uncertainty is higher and hence the investors demand a higher maturity risk premium. However, the bonds with smaller maturity period tend to offer a lower bond yield due to lesser risk (Damodaran, 2010). This can be viewed with the statistics that on January 27, 2017, the bond yield was 2.307 % for the 5 year fixed coupon Australian treasury bonds. On the same date, the corresponding yield was 2.797% for 10 year fixed coupon bonds (RBA, 2017).

It has been observed that when the economy becomes pessimistic in nature then the risk free interest rate tends to decline. In this environment, the risk premium rate also gets increased. A bond with a BB rating is not considered attractive from investment point of view in such a scenario because of the high underlying risk. As a result, the demand of such bonds would decrease and the investors would now prefer to invest in blue chip companies bonds or the treasury bonds. Therefore, the bond yield would tend to increase in the pessimistic economy so as to be able to compensate the investors for higher risk.

There is an inverse relationship between the bond yield and price of bond. As the bond yield increases which is evident from the falling demand, the price of the bond would also fall. Also, the risk averse climate would add to the price pressure as demand would continue to remain low even at low value due to high perceived risk (Ross, Trayler and Bird, 2007).

Question 5

The required return on the company’s shares by using CAPM model is as highlighted below (Ross, Trayler and Bird, 2007).

Beta of the company’s stock

Risk free rate (as on 30June 2015)

Market risk premium =

Now,

Therefore, the required return on the company’s shares as at 30June 2015 is

If beta of the company’s stock and market risk premium is same then the required return on the equity is computed as (Ross, Trayler and Bird, 2007).

Market risk premium = 6.80%

Beta of the company’s stock

Risk free rate (as on 30 June 2016)

Therefore, the required return on the company’s shares as at 30June 2015 is

It can be observed from the above computation that a significant decrease is obtained in the required retune on the company’s share in FY2016 because the risk free rate declines in the latter case.

It is noteworthy that this is a hypothetical case because, when the risk free rate decreases then it is apparent that the investors are becoming more risk averse.. Hence, the investors would prefer to invest into more secure assets. In this scenario, the value of the expected returns should be greater because the company has to compensate the investors for the additional risk (Brealey, Myers and Allen, 2012).

When the average risk aversion in the market falls, this would result in lowering of the required return on company’s shares. Additionally, the investors of the company would plan to invest in safer assets.

Question 6

The company’s FCF and ROIC for the financial years FY2015 and FY2016 are as given below (Morningstar, 2017).

For Financial year FY2015

FCF = $137 million

ROIC = 29.39%

For Financial year FY2016

FCF = $133 million

ROIC = 31.06 %

It is evident based on the above analysis that the company is deriving a good FCF which is stable. Moreover, the ROIC of the company has increased in financial year 2016 as compared to the financial year 2015. It is imperative to note that the value of the ROIC is higher than the WACC of 7 %. This is indicative of value addition on the part of the company, which is beneficial for the concerned shareholders as it potentially leads to long term value creation (Brealey, Myers and Allen, 2012).

Reference

Brealey, R.A., Myers, S.C. and Allen, F. (2012) Principles of corporate finance. 2nd edn. New York: McGraw-Hill Inc.

Damodaran, A. (2010) Applied corporate finance: A user’s manual. 3rd edn. New York: Wiley, John & Sons.

Morningstar (2017), JB Hi Fi Ltd, Morningstar Website, [Online] Available at https://financials.morningstar.com/ratios/r.html?t=JBH&region=aus&culture=en-US [Accessed March 24 2017]

RBA (2017), Interest Rates, Reserve Bank of Australia, [Online] Available at https://www.rba.gov.au/statistics/historical-data.html [Accessed March 24 2017]

Ross, S.A., Trayler, R. and Bird, R. (2007) Essentials of corporate finance. Sydney, Australia: McGraw-Hill Australia.

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