TFIN603 Corporate Finance

1. Assume you decide you should invest at least part of your money in an All Ordinaries Index fund of companies based in Australia. What are the advantages and disadvantages of choosing the All Ordinaries Index fund compared with the Bond Fund? [10 marks]
2. The returns of the Down Under Property Trust Fund are less volatile than those of the All Ordinaries Index fund, but more volatile than the rest of the managed funds offered in the superannuation fund. Why would you ever want to invest in the Property Trust Fund? When you examine the expenses of the funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund? [10 marks]

• A measure of risk-adjusted performance that is often used in practice is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviations and returns for the funds over the past 10 years are listed below. Assuming a risk-free rate of 4%, calculate the Sharpe ratio for each of these. In broad terms, what do you suppose the Sharpe ratio is intended to measure? [10 marks]

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Question 4 Total Marks: 20

Dick Davies, the owner of Davies Gold Mining, is evaluating a new gold mine in Tanzania. Barry Koch, the company's geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Barry has taken an estimate of the gold deposits to Andy Marshall, the company's financial officer. Andy has been asked by Dick to perform an analysis of the new mine and present his recommendation on whether the company should open the new mine.

Andy has used the estimates provided by Barry to determine the revenues that could be expected from the mine. He has also projected the expense of opening the mine, and the annual operating expenses. If the company opens the mine, it will cost $500 million today, and it will have a cash outflow of $80 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the following table. Davies Gold Mining has a 12 per cent required return on all of its gold mines.

Using the information provided, answer the following questions:

1. Andy is asked by Dick to rank the different valuation methods by how appropriate they are for analysing the project. Rank the different methods used. [10 marks]
2. In discussing the payback period rule Dick asks Andy to highlight its strengths and weaknesses. What are they? [5 marks]

• In analysing the mine, Andy advises Dick that this mine is riskier than other mines in the Davies Gold Mining portfolio and so the discount rate should increase. Explain what impact will this have on the cash flows of the project. [5 marks]

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END OF THE EXAMINATION

I have solved only half of it, it is for question no. 3 and question no. 4

Answer I.

We need to calculate the coefficient of variation and the formula is as follows

= Standard Deviation / Mean * 100

Coefficient of variation for All Ordinaries Index Fund = 19.35/9.15 * 100

= 211.48%

Coefficient of variation for Bond Fund = 23.82/9.53 * 100 = 249.95 %

Advantage and Disadvantage of choosing the All Ordinaries Index Fund is as follows :

1. As we are able to see from the data provided in the question as well as from the calculation of Coefficient of Variation we can see very easily that the return is bit lower than than the Bond Fund but the Standard Deviation of Bond Fund is much higher than the All ordinaries Index fund. The Coefficient of variation is also quit high is 249.95% compare to 211.48 % of all ordinaries index fund. Hence the Bond fund is more risky than the All ordinaries index fund .
2. As we have seen from the basic characteristic of investment in the All Ordinaries index fund that the index is calculated on the basis of weighted average methods. Means that the fund’s return is approximately the return of all ordinaries Index minus Index. In this investment even the management need not spend much time on research the shares and the market and it is less risky also than the Investing into the long term corporate bond in Australia as well as new Zealand.
3. When we see that fund manager charges it is also very low for the all ordinaries index funds compare to the bond funds . it is only 0.20 % compare to bind fund charges of 1.40% in expenses.

Hence by comparing all the above points we can make a conclusion that if we want to invest at least part of company we will be giving priorities into investing into All ordinaries index funds of companies based in Australia Over and above the investing into the bond fund of long term corporate bond issues by the companies domiciled in Australia as well as New Zealand.

Answer of II.

Calculation of coefficient of variation for all the fund investments .

From the above table we are able to see that returns from Down Under property Trust fund are less volatile than the all ordinaries fund but more volatile than the Money market fund, It is also less volatile than the Bond funds. But we are able to see from the above calculation that property trust Fund return is highest among the all types of investment funds. It gives us all most 5 % approx. estra return than any other funds. It comes to almost increase in the returns of 50 % approx.. compare to all other funds. Yes together with the average return it standard deviation is highest among the all types of funds but when we have calculated the COEFFICIENT OF VARIATION, we found that its coefficient of variation is lesser than the ordinaries index fund as well as money market fund hence it is advisable into the property trust fund. The expenses of fund will not have any impact because when we calculate the returns it is deducted hence the rate of expenses will not have any impact of the decisions.

Solution Q no. 4

1. Calculation of payback periods

In the fourth year we need additional cash flow for pay back period

= $ 500,000,000 – $ 320,000,000 = $ 180,000,000

Pay Back Period = 3 years + 180,000,000/230,000,000

= 3 years + 0.783 years

= 3.783 years

= 3 years & 10 months approx..

2. Net Present Value ( NPV) ( Amount in $)

1. Calculation of IRR ( Amount in $)

( Amount in $)

At 15% our NPV = $ 67,555,000

At 20% our NPV = - $ 17,480,000

IRR = 15 % + 67,555,000/ 85035000* 5

= 15 + 4.96

= 19.96 %

Conclusion :

Our NPV @ 12 % = + $ 133,965,000

Our IRR = 19.96%

Our Pay Back Period Is = 3 years & 10 months

The life of the project is 8 years and pay back period is just 3 years & 10 months hence according to pay back period the project must be selected .

NPV = is + $ 133,965,000 so according to NPV project must be selected and it is advisable for Davies Gold Mining to invest into this projects.

IRR = 19.96% and it is much more than the cost of capital that is 12 % hence according to this approach the project must be selected.

Now comparing with all the tools we will rank first to IRR as it calculate the exact return of the project and give us the real picture of exact return. NPV is ranked second and Pay back period is ranked third as pay back period is not considering the future cash flows after the pay back period .

2. In discussing the payback period Dick highlighted its strength and weakness which as follows.

Strength :

1. Payback period is simple and easy to calculate .
2. It gives us an indication of probability.
3. In border sense , the payback period deals with the risk also. The project with a shorter period will be less risky than the project with a higher period.

Weakness:

1. This method ignores all the cash flows which inflows after the payback period.
2. It ignores the timing of the occurrence of the cash flows
3. The pay back period also ignores the salvage value of the project.

3. If the discount rate will increase than upto 19% it will have positive NPV but if it goes beyond the project will have negative NPV and the cost of capital will increase from its IRR and the project will become unviable. This is the suggestion give by Andy to Dick.