MPA801 Capital Markets and Finance |Expected Rate of Return
Questions:
1.Get Rich Investments is buying a 90 day original term to maturity day bank bill today. The bill matures in 75 days’ time. The bill has a face value of $1,500,000 and the current yield on this bill is 5%. Note that this is a quoted annual interest rate. How much will Get Rich Investments have to pay to buy the bill?
2.In Question 1, after 45 days of holding the bill, Get Rich Investments wants to sell the bill on the secondary market. At that time, yields for 45 day bills are 4.65% and 30 day bill yields are 4.50%. What is the price that Get Rich Investments will receive when it sells the bill?
3.Solvents Inc., an industrial company in the USA, decides to issue 0.5 million 20-year bonds with a face value of $1000 and semi-annual coupon payments. The effective annual rate or yield on other commercial and industrial bonds of similar risk is 7.25%, so the company decides to offer 8% annual coupon to attract investors. What capital will Solvents Inc raise from the issue of the bonds assuming that an investment bank has fully underwritten their offer for a fee of 2% of face value plus $1 Million in legal costs. Show all workings.
4.aImagine that immediately after issue, the general level of interest rates in the U.S. economy moves to such an extent that the value of the Solvents Inc bond shifts to exactly $1000.What would now be the
new bond-equivalent yield (the one that will be advertised in the financial press as an annual rate and is sometimes called Quoted Interest Rate)?
b.What would now be the new effective annual yield or rate (EAY or EAR)?
5.Westpac Ltd periodically issues preference shares to investors. Westpac is a commercial bank mainly operating in Australia and New Zealand. A batch of preference shares that was issued in 2016 pays a fixed dividend of A$5 per year. These preference shares are currently selling at A$80 (as quoted on the ASX). The company has just released a new 5 year profit plan which predicts that earnings will grow at the rate of 4 per cent annually.
a.What is the expected rate of return if investors are buying Westpac preference shares in the secondary market today at A$80?
b.If you, an individual investor, had a required rate of return of 7 per cent, what is the maximum price you should be willing to pay for these shares in Australian dollars?
6.You are considering the purchase of 1000 ordinary shares in NAB Ltd. NAB is a commercial bank predominantly operating in Australia and New Zealand. NAB only pays a dividend once a year to shareholders but has a very generous dividend payout ratio of 75%. Annual Earnings per Share are currently A$2.80. Security analysts have a consensus view that NAB will succeed in growing these earnings at a rate of 4% per year
The current market risk premium is 6% from investing in major listed shares in Australia. NAB currently has a beta of 1.2. This is worrying you as you have done some research and find that the average historical beta for NAB over the last 20 years has been 1.0. A recent graduate of Melbourne Polytechnic who studied this unit has told you that the high beta is because of enhanced volatility around NAB returns stemming from several major scandals it was recently involved in.
You look at the NAB share price on the internet and see it is trading currently at $30.25. It was trading at $35 before the scandals went to press.
You are of the opinion that NAB will be able to maintain a 75% dividend pay-out ratio even in the event of having to pay fines and other penalties in relation to the scandals.
b.Should you buy the shares at their current trading price? You need to run a calculation as well as provide reasoning.
7.“Rough & Ready Constructions Pty Ltd” in Perth is considering some new equipment. This new equipment will generate new sales revenue. No existing equipment will be replaced. The new equipment has a 3-year life for depreciation purposes under Australian tax regulations and would be fully depreciated by the prime cost method over those years. It is planned to close down the project at the end of Year 3. The company will need to increase its net operating working capital at the beginning of the project but no further increases are foreseen. Revenues and other operating costs are expected to be constant over the project's life.
|
Data concerning the project is tabled below: |
|
|
Required return for projects of this risk level |
12% |
|
Assignment S1 2018 |
p. 3 |
|
New investment in fixed capital |
$240,000 |
|
Additions to inventories at outset of project |
$22,000 |
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Additions to trade accounts receivable at outset of project |
$14,000 |
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Additions to trade accounts payable at outset of project |
$18,500 |
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Incremental sales revenue of the firm |
$200,000 p.a. |
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Incremental cash operating costs of the firm |
$75,000 p.a. |
|
Expected pre-tax salvage proceeds |
$50,000 |
|
Company tax rate |
30% |
Required:
b.With appropriate justification, briefly explain whether the company should undertake the project or not
8.“Bull at a Gate Fabrications Pty Ltd” is a manufacturing business based in Sydney. Their company tax rate is 30%. It is considering the replacement of a manually operated machine with a fully automated model. Currently 6 full-time operators are needed to operate the machine. This labour costs the company $320,000 p.a. in wages, holiday pay and compulsory superannuation payments to the employees’ selected funds. In addition, maintenance costs are $32,000 per year.
The machine was bought 4 years ago for $200,000. The Australian Tax Office schedule includes the asset in the 12 year useful-life category and only allows prime cost depreciation (with no residual) for this type of plant and equipment. The company believed that the machine normally would be taken out of service at the 12-year point.
The current disposal value of the machine presently in use is $50,000. The new model has a purchase price of $570,000. It is estimated that shipping and installation would cost $30,000. Maintenance on the new machine would be $60,000 p.a. but the adoption of that machine would cut the cost of defects from $20,000 to $4,000 per year.
The new machine is in an 8 year useful life tax category (with no residual). As the machine will undergo heavy use, the company believes the 8 years may be quite accurate.
The company expects the manufacturing business will close down after 8 years of operation of the new machine and that the machine will have no re-sale value at that point.
The required rate of return for projects of this risk level is 10%.
Required:
b.Compute the NPV and advise if you would recommend the project. Included in your summing-up of the project you should make a comment on the IRR value of the project and why the IRR would have to be more or less than required rate of return (7 marks).
9.aYou are evaluating two different audio systems. Ear Surround costs $45,000, has a three-year life and costs $5 000 per year to operate. The Audio-Aura costs $65,000, has a five-year life, and costs $4,000 per year to operate. The relevant discount rate is 8 per cent and corresponds with an 8% before–tax cost of debt, with project totally debt-financed. Ignoring depreciation and taxes compute the AEC for
both systems. Which one would be preferred if we assume zero salvage value at the end of life for both systems?
b.Now assume that prime cost (reflecting their respective lives) is used for both audio systems for tax depreciation purposes. The relevant tax rate is 30 per cent and tax is paid in the year of income. Assume that salvage value for both systems is $10,000. The relevant discount rate however drops to 5.6 per cent [8% * (1-30%)].Compute the AEC for both systems. Which is preferred now?
Answers:
1.
As per the question provided, Get Rich Investment is to buy a 90 days original term bill which has a maturity date of 75 days. The bill has a face value of $ 1,5,00,000 and has a yield of 5%. The calculations for the bill are shown below:
Figure 1: (Image Showing Calculation of Purchase price)
Source: (Created by Author)
The purchase price of the bill as shown in the calculation above is $ 14,84,669.
2.
Figure 2: (Image Showing Calculation of Market Price)
Source: (Created by Author)
As per the requirement of the question, the market price of the bill is to be calculated which is shown in the table above. As per the case, Get Rich Investment ltd has hold the bills for a period of 45 days. The yield which is available for a holding period of 30 days is 4.50%and for a holding day period of 45 days the yield is 4.65%. The market value of the bill after a period of 45 days will be $ 14,91426 and the market price at the end of 30 days will be $ 14,94,463. The sacrifice of interest rate as shown in the above table comes to about $ 5,537. After adding the market price for a holding period of 45 days with the sacrifice of interest rate, the expected selling price of the bill can be calculated.
3.
Figure 3: (Image Showing Calculation of Total Fund Raised)
Source: (Created by Author)
4.
Figure 4: (Image Showing Calculation of Bond Equivalent Rate)
Source: (Created by Author)
As per the requirement (b) of the question, the new effective annual will be 8% as the fair value of the bond and market value of the bond remains same at $ 1000. For such a purpose the bond equivalent rate also becomes zero percent.
5.
As per the question Westpac ltd is a commercial bank which is engaged in issuing preference shares for a fixed dividend. The expected rate of return for investors who are buying the preference shares is calculated to be 10.50% which is shown in the chart below:
Figure 6: (Image Showing Calculation of Maximum Market Price)
Source: (Created by Author)
In figure 6, requirement (b) of the question is shown in the above image which shows that the maximum market price which an individual expecting 7% return can earn is shown above which is $ 173.33.
6.
Figure 8: (Image Showing Calculation of fair value of shares)
Source: (Created by Author)
As per the calculations, the shares are being traded at $ 30.25 which is below the fair value of the shares as shown in the table above. This signifies that the shares are coming at a cheaper rate and therefore the shares should be purchased. The investors should invest in the shares of the company as the company is currently trading below the fair value of the shares.
7.
Figure 9: (Image Showing Calculation of Net Present Value)
Source: (Created by Author)
As per the definition of net present value, it is the difference between the presented value of the discounted cash flow of the business and present value of initial investments or cash outflow of the business. In simple words, it is a technique which is used by businesses to determine the cash inflows which the business can expect in future from the project (Hu et al. 2013). NPV analysis is done by businesses to determine the financial feasibility of any particular project before investments are made in the project. In the above case the NPV analysis considers sale revenue cost of operations and depreciation expenses to determine the Net present value of the project. The net present value of the projects comes to about $ 35,216 which is a positive figure which means that the project is worth making investments.
The company should undertake the project as the NPV analysis shows a positive figure of $ 35,216 which is evident enough that the project will be generating revenues which will be more that the costs of initial investments which were undertaken by the company.
8.
Figure 10: (Image Showing Calculation of Net Incremental Cash flow)
Source: (Created by Author)
The company should invest in the project as the NPV of the project is in positive and moreover the IRR of the project is more than the required rate of return which clearly indicates that the project must be invested in (Rossi 2015). If the IRR is more than required rate of return means the project has the capability to generate revenues in spite of risks. Whereas if IRR is lower than required return rate than the risks of the projects are more and hence not worthwhile investing.
9.
Figure 11: (Image Showing Calculation of NPV)
Source: (Created by Author)
The Ear Surround will be preferred more on the basis of the NPV analysis as the losses earned is lower in this system.
Figure 12: (Image Showing Calculation of NPV and AEC)
Source: (Created by Author)
The Ear Surround will be preferred on the basis of NPV analysis of the same as given in the chart above.
References
Hu, Y., Li, X., Li, H. and Yan, J., 2013. Peak and off-peak operations of the air separation unit in oxy-coal combustion power generation systems. Applied energy, 112, pp.747-754.
Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.
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