CORPORATE FINANCE & FINANCIAL MANAGEMENT ASSIGNMENT -

TASK -

Question 1 - Y Ltd Shares have a beta of 1.6 and an expected return of 21.0%. Shares in Z Ltd have a beta of 1.03 and an expected return of 13.5%. If the risk-free rate is 5.2% and the market risk premium is 9%, are these shares correctly priced? Discuss and use numbers to make your explanation clear.

Question 2 - ExxonMobil is approached by another oil company called Chevron who finds itself in a situation of squeezed liquidity. Chevron is aware of that ExxonMobil is often open to investing in Promissory Notes of strong industrial companies for periods ranging from 2 to 5 months. Chevron is having difficulty calculating the best length of time the contract should run for but knows it will be able to afford to pay back ExxonMobil $US 50 million. It also knows ExxonMobil will need to advance less than that sum. How much will Chevron receive from ExxonMobil at day one of the arrangement under various scenarios of 60, 90, 120 and 150 days original time to maturity of the financial instrument if yields on Promissory Notes issued by companies of similar risk to Chevron are as follows:

60 days ... 7.50%

90 days ... 8.00%

120 days... 8.00%

150 days... 8.05%

Question 3 - With reference to Question 2 above what is the Effective Annual Rate (%) of the cost of funds in the four scenarios? What two periods would you advise Chevron to avoid in order to avoid the most expensive financing?

Question 4 - With reference to Questions 2 and 3 above, consider the possibility that ExxonMobil may get cold feet before the deal is signed and start insisting that the default risk be transferred to Chevron's bank. That bank would then become the acceptor of a bank bill and would need to charge Chevron on day one of the deal a fee of $100,000 in the event the period struck was 60 days.

Calculate the Effective Annual Rate (%) of the cost of funds to Chevron under this scenario.

Question 5 - Dodgy Chemicals Inc., an industrial company in the USA, decides to issue 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 and time to maturity is 9%.

Because of liquidity constraints the company decides to offer 8% annual coupon. What would be a fair price for these bonds? Show all workings.

Question 6 - This question follows on from question 5 above.

(a) Imagine 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 Dodgy Chemicals 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 also called Quoted Interest Rate)?

(b) What would now be the new effective annual yield or rate (EAY or EAR)?

Question 7 - Smart Manufacturing Pty Ltd in Canberra 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%

New investment in fixed capital $240,000

Additions to inventories at outset of project $22,000

Additions to trade accounts receivable at outset of project $14,000

Additions to trade accounts payable at outset of project $18,500

Incremental sales revenue of the firm $200,000 p.a.

Incremental cash operating costs of the firm $75,000 p.a.

Expected pre-tax salvage proceeds $50,000

Company tax rate 30%

Required:

(a) What is the project's NPV?

(b) With appropriate justification, briefly explain whether the company should undertake the project or not.

Question 8 - Rough Jobs Pty Ltd is a manufacturing business based in Tasmania. 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 labor 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:

(a) Determine the cash flows associated with this replacement project.

(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.

Question 9 - This is a bonus question

(a) You are evaluating two different computer servers for the business you work for. Server X costs $450,000, has a three-year life and costs $50 000 per year to operate. Server B costs $650,000, has a five-year life, and costs $40,000 per year to operate. The relevant discount rate is 8 per cent and corresponds with the 8% before-tax cost of debt. Ignoring depreciation and taxes, compute the Annual Equivalent Cost (AEC) for both servers. Which one would be preferred?

(b) Now assume that prime cost (reflecting the respective lives of the asset) is used for servers 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 servers. Which is preferred now?