QUESTION 1

a) This question relates to risk and return.

Billy Black has invested one-quarter of his funds in Share A and three-quarters of his funds in Share B.

The expected return on Share A is 14% and on Share B is 20%. The standard deviation of share A is 17% and on Share B is 24%. The correlation between returns is 0.5.

What are the expected return and the standard deviation on Billy's portfolio?

ii) Is Billy better off by maintaining his existing two- share portfolio, or should he have invested all his funds in one security, and if so, which one?

Give reasons for your recommendation.

b) This question relates to the valuation of bonds. Sarah Green, a retired school teacher, has two 8 per cent per annum $100,000 Australian Government bonds that mature on 15 April 2019 and 15 April 2023 respectively. At the date of the last half-yearly interest payment, viz., 15 October, 2016, both bonds were selling at par.

Since then, interest yields on bonds have risen by 2% per annum, compounded half-yearly. Sarah now intends to sell the bonds and put a deposit on a country property.

1) Calculate the price she will receive from each bond if she sells on 15 January, 2017 at the new yield. [Hint: There are 92 days from 16 October, 2016 to 15 January, 2016 inclusive, and 182 days from 16 October, 2016 to 15 April, 2017.]

i) Explain the relative price movements in the two bonds, as evidenced in your answer to i) above.

QUESTION 2

This question relates to capital budgeting.

Capital Constructions Ltd is considering the purchase of equipment costing $400,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 5 years.

The new equipment will permit the company to reduce its to reduce its labour costs by $170,000 a year for 5 years, and the equipment may be depreciated for tax purposes by the straight-line method to zero over the 5 years. The company thinks that it can sell the equipment at the end of 5 years for $30,000.

The equipment will need to be stored in a building, currently being rented out for $20,000 a year under a lease agreement with 5 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Capital Constructions Ltd can cancel the lease by paying the tenant (now) compensation equal to one year's rental payment plus 10%, but this amount is not deductible for income tax purposes.

This is not the first time that the company has considered this purchase. Twelve months ago, the company engaged Clever Consultants, at a fee of $23,000 paid in advance, to conduct a feasibility study on savings strategies and the company made the above recommendations. At the time, the company did not proceed with the recommended strategy, but is now reconsidering the proposal.

The company further estimates that, starting in 2 years' time, it will have to spend $10,000 every 2 years overhauling the equipment. It will also require additions to current assets of $27,000 at the beginning of the project, which will be fully recoverable at the end of the
fifth year.

Capital Constructions Ltd's cost of capital is 14%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

REQUIRED:

(a) Calculate the net present value, that is, the net benefit or net loss in present value terms of the proposed purchase and the resultant incremental cash flows.

(b) Should the company purchase the equipment? State clearly why or why not.