Question 1.

Brown Ltd operates outdoor amusement centres in a number of country towns. The company has decided to build another centre that is expected to generate a permanent increase in EBIT of $100,000 pa. Current EBIT is $350,000. Brown currently has a capital structure that utilises bonds, ordinary equity and preference shares. The $200,000 of issued bonds pay 8% pa. Preference shares pay an annual fixed dividend of $150,000. Currently 250,000 ordinary shares have been issued and are trading at $2 per share. The company pays tax at 30%.

a) Brown needs to raise $500,000 to construct the new amusement centre. Assuming the company can issue new shares at the current market price, what is the impact on EPS if new shares are issued to fund the centre?

b) If new debt can be raised at a 10% interest rate, what is the impact on EPS of using debt rather than a new equity issue?

Brown Ltd depends on mainly on sunny weather to generate its expected EBIT. Using the information above together with the two following scenarios calculate the impact of the debt and equity financing alternatives if:

a) Weather is good which will increase attendances and increase EBIT to $600,000

b) Weather is poor which will decrease attendances and reduce EBIT to $320,000

c) Calculate the indifference point

Question 2.

You are considering the following two stocks for your portfolio and have observed the following.

The risk free rate is 0.04 and you are considering investing 60% of your funds in Stock A and 40% in Stock B.

Calculate the following.

a) Expected Return of Stock A

b) Expected Return of Stock B

c) Standard Deviation of Stock A

d) Standard Deviation of Stock B

e) Coefficient of Variation of Stock A

f) Coefficient of Variation of Stock B

g) Covariance of Stocks A and B

h) Correlation Coefficient of Stocks A and B

i) Portfolio Return

j) Portfolio Standard Deviation and Variance

k) Weights of the Minimum Variance Portfolio

l) Proof that these weights lead to the Minimum Variance Portfolio

m) Weights of the Optimal Risky Portfolio with a risk-free asset

n) Proof that these weights lead to the Optimal Risky Portfolio

o) Discussion on what you would do with this portfolio

Question 3.

Herbicide Ltd manufactures insecticide which is marketed in one and two litre bottles. The existing machinery owned by the company for the bottling of its product has now reached the end of its useful life, and the management of the company is deciding what equipment should be purchased to replace it. It is not necessary to replace the ancillary machinery which includes conveyor belts, washing and inspection machinery and other equipment.

Machines Under Consideration

The new bottle filling and capping machines being considered are:

1.The 'Bottle-Snap'.

2.The 'Seal'.

3.The 'Zip Cap'.

4.The 'Screw-Top'.

The 'Bottle-Snap' is an improved version of the existing equipment to be retired. This machine has a nominal capacity of 370 bottles per minute (bpm) for one litre bottles, or 125 bpm for two litre bottles.

The 'Seal' is a similar machine to the above, except that it has a much larger capacity. Its nominal capacity is 600one litre bpm or 280two litre bpm.

The 'Zip-Cap' uses tear-off caps and operates at a maximum (nominal) rate of 350 one litre bpm. This machine could be used to fill and seal two litre bottles, but with a greatly reduced production rate.

The 'Screw-Top' can be used to reseal bottles after the initial opening. The nominal capacity of this machine is 200 two litre bpm. This machine could be used to fill and seal one litre bottles.

Departmental managers have determined the following average production capacities based on the preceding nominal (maximum) capacities of each machine.

Sales

The present annual sales volume of the company is approximately 1,600,000 24-bottle crates of one litre bottles, and 1,400,000 12-bottle crates of two litre bottles.

The current selling price per crate for the company's insecticides is as follows:

• $1.20 per 24-bottle crate of one litre bottles
• $1.60 per 12-bottle crate of two litre bottles

The additional costs involved in the production of two litre 'Screw-Top' bottles would require a selling price of $1.75 per 12-bottle crate if this type of bottle were to be marketed.

Conventional or New Seals

The final choice has been narrowed down to five alternative proposals which are set out in Exhibit 1

Identification of Costs

a An initial investment allowance of 20 per cent is allowable for taxation purposes on the initial investment and installation costs.

Depreciation, at the rate of 20 per cent per annum (straight line), is allowable for tax purposes on all three items of expenditure required for acquisition, installation and parts inventory.

b.Annual fixed operating costs exclude depreciation.

c.Variable operating costs exclude taxation expenses. "Normal" variable operating costs per crate are those estimated for production at normal rates of pay. "Penalty" variable operating costs per crate are those estimated for production during periods when penalty rates of pay apply (late shifts and weekends)

The Production Manager has prepared estimates of the total annual production hours required to meet expected sales for each of the five alternative proposals. These estimates are based on the expected average rate of production per hour, and separate 'normal' production hours from 'penalty' production hours. The Production Manager's estimates are reproduced in Exhibit 3.

EXHIBIT 3

Production Hour Estimates

The company uses the net present value method in its capital budgeting decisions. The after tax required rate of return is 10%. Income tax rates for simplicity are 50%. Assume that any taxation implications occur at the time of the relevant cash flow or in the case of depreciation, in the year of the depreciation claim. Assume also that all cash flows take place at the end of each period and that inflation is zero.

Required

1) Show the cash flows for each alternative proposal listed in Exhibit 1.

2) Compute the Net Present Value, Payback Period and the Internal Rates of Return for each alternative.

3) On the basis of your analysis in question 2, which of the alternatives would you recommend?