Question : 1

Top Shelf Bakers Ltd. are considering two mutually exclusive investment projects with expected cash flows as given below:

Project A is an expansion of an existing product line and is considered to have the same level of risk as other projects at Top Shelf Bakers.

Project B is an expansion into a new market and is considered much riskier than other projects at Top Shelf. Other companies operating in this new market have a typical β = 1.6

Top Shelf's current required rate of return = 8.0% pa.

The current market rate = Rm = 12.3% pa; The current risk-free rate is = Rf = 2.5% pa;

Requirement:

i) Which project, if any, should be selected, and why? 8

ii) If the projects were not mutually exclusive, what would be your recommendation, and why?

iii) Discuss the causes of conflict in project evaluation measures, and how you would determine the most appropriate measure to use when
conflict occurs

Question 2:

Your favourite Auntie has asked you for advice on investing $100,000 of her superannuation payout in some shares.

Knowing that diversification is a way to reduce the risk associated with share investments, you have investigated 6 different shares for their possible inclusion in a portfolio, and this information is presented below:

The expected rate of return for the 6 shares over the next 12 months are:

CBA = 19.3% Rio Tinto = 4.2%
Qantas = 15.5% Toll = 18.3%
Woolworths = 9.8% Origin = 8.6%

Other information based on the past performance of these shares has been collected and is given as follows:

The beta values for these shares:

βCBA = 0.96 βRio Tinto = 1.36

βQantas = 1.50 βToll = 1.71

βWoolworths =0.48 βOrigin =0.60

The current market return Rm = 12.3%; The current risk free rate Rf = 2.5%

Required:

i) Calculate the required rate-of-return for the 6 shares (round to 2 decimals).

ii) Create a graph using the variables Beta and Rate-of-Return as the X and Y axis respectively.

Then, using the information provided and your answers to part i):

• Draw the market security line on the graph;

• Plot the points representing the position of the 6 shares (ie their expected rate position).

iii) Comment on the position of the 6 shares about the market security line, and what this means with respect to their investment potential.

iv) Which of these securities would you recommend buying, and why? 2

Question 2-B

Regardless of your recommendations in Q2-A iv) above, you have decided to create a portfolio with the following investment amounts for your Auntie:

Required:

Calculate the beta and expected rate-of-return of this portfolio (round beta to 2 decimals and expected return to 1 decimal).

Question 2-C

In your own words, discuss the limitations of the Capital Asset Pricing Model and its use in evaluating share investments. (approx. 250 words) 6

Question 3

Jacque Oliver is a sole trader, owner and manager of a bakery business in the south of Adelaide.

Her oven has broken down and she is now faced with a choice - a significant repair / alteration to the existing oven or to purchase a new oven.

Repairing the existing oven would be cheaper but there have been significant advances in oven design in recent times, and a new one would speed up the operations, cut energy costs, and allow her to expand the range of products.

The existing oven was purchased 3 years ago for $32,000 and had an expected life of 8 years with zero salvage value (straight line depreciation). The repair would cost $4,000, and would be depreciated over the remaining life of the oven and with no change to its salvage value.

If the new oven is purchased, Jacque can sell the old oven, in its existing condition, for $8,000. The new oven would cost $65,000 plus setup and installation costs of $3,000. There would also be initial training costs of $1,000, and inventory would have to increase from current levels of $2,000 to $3,000 to cater for the increased range of products.

The new oven has an expected life of 5 years and a salvage value of $15,000 (straight line depreciation), and is expected to increase sales by $20,000 per year and reduce energy costs by $2,400 per year. Unfortunately Jacque would have to take out a loan to help finance the purchase, incurring interest costs of $3,000 per year.

Jacque has a marginal tax rate of 45% and, after considering all factors in the proposed new purchase, has set an after-tax required rate of return of 16.0% pa.

Required:

i) What is the initial outlay that should be included in any evaluation of the proposed purchase of the new machine?

ii) What are the incremental cash flows for the 5 years of operation of the proposed new machine?

iii) Should Jacque go ahead with the proposed purchase, and why? 6

Question 4

Hot Stuff Energy Ltd. is considering the development of a geothermal power station, to be located north of Port Augusta in South Australia. This is considered an important project because, if successful, it would provide cheap, clean power to nearby housing and businesses.

The project is expected to have an initial outlay of $200million and generate cash inflows of $64million for the next 12 years. Operating costs (cash outlays) will be $16million in the first year but, because of the corrosive nature of the heat exchange process, the operating costs expected to increase at a rate of 10.0% per year.

Hot Stuff has a required rate of return of 16.0% pa on this type of project.

Required:

i. Determine the viability of the project on the basis of the expected 10% per year growth in costs.

ii. There is some uncertainty in the expected rate of growth in the costs, so perform a sensitivity analysis and determine the project's viability using figures of 5.0% pa and 15.0% pa growth rates.