QUESTIONS
Q1. In the last decade there has been a shift towards the direct transfer of funds from investors to the corporate sector. Examine some of the reasons for this trend.
Q2. (Annuity payment and term loan) On 31 December Liz Klemkosky bought a yacht for $50000, paying a deposit of $10000 and agreeing to pay the balance in 10 equal annual instalments that would include both the principal and 10% interest. How big would the annual payments be?
Q3. What is the efficient markets hypothesis? Explain this concept in your own words.
Q4. Some practising financial analysts focus on earnings per share (EPS) as a major determinant of the firm's share price.
(a) Explain the link between EPS and the share price.
(b) What are the limitations of this approach to share valuation?
Q5. (Bond valuation) You own a bond with a par value of $1000 that pays a $100 annual coupon. The bond matures in 15 years. Your required rate of return is 12% p.a.
(a) Calculate the value of the bond.
(b) How does the value of the bond change if your required rate of return (i) increases to 15% p.a., or (ii) decreases to 8% p.a.?
(c) Assume that the bond matures in 5 years instead of 15 years. Recomputed your answers in part (b).
Q6. (EAAs) Greenberg Trading is considering two mutually exclusive projects, one with a four-year life and one with a nine-year life. The net cash flows from the two projects are as follows:
YEAR PROJECT A PROJECT B
0 -$160000 -$160000
1 65000 35000
2 65000 35000
3 65000 35000
4 85000 40000
5 40000
6 40000
7 45000
8 45000
9 45000
(a) Assuming a 10% required rate of return on both projects, calculate each project's EAA. Which project should be selected?
(b) Calculate the present value of an infinite-life replacement chain for each project.
Q7. (Integrated problem) Correlli Ltd, a taxation category 2 company, has done some preliminary evaluation of the following four investment projects, as detailed below.
Investment Investment cost Rate of return (%)
A $200000 18
B 125000 16
C 150000 12
D 275000 10
The latest balance sheet for the company shows:
Long-term debt $
Bonds: Par $100, annual coupon 16.35%, 5 years to maturity 1 500000
Equity
Preference shares (55000 shares outstanding, 94 cents dividend) 550000
Ordinary shares (825000 shares issued) 1 650000
Total $3 700000
The company's bank has advised that the interest rate on any new debt finance provided for the projects would be 8% p.a.
The company's preference shares currently sell for $9.09, and to induce investors to take up a new offering of preference shares the company would have to set the issue price at a discount of 4% off the present market price.
The company's existing shares sell for $3.03 each and management has disclosed that it expects to pay a dividend of 16 cents at the end of the next year. Historically, dividends have increased at an annual rate of 9% p.a. and are expected to continue to do so in the future. The ordinary equity component to finance new projects will require new shares to be sold at a 10% discount from the current $3.03 price, and the costs for undertaking the new issue are estimated to be 30 cents per share. The company tax rate is 30%.
(a) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company's capital structure.
(b) Calculate the after-tax costs of finance for each source of finance.
(c) Determine the after-tax weighted average cost of finance for the company.
(d) Determine which investments should be made?
Q8. (Cost of a term loan) Temple Freight Forwarding Company needs $300000 to finance the construction of several prefabricated metal warehouses. The firm that manufactures the warehouses has offered to finance the purchase with a $50000 down-payment followed by five annual instalments of $69000 each. Alternatively, Temple's bank has offered to lend the firm $300000 to be repaid in 10 halfyearly instalments based on a nominal annual rate of interest of 16%. Finally, the firm could finance the needed $300000 through a loan from a finance broker requiring a single lump-sum payment of $425000 in five years.
(a) What is the effective annual rate of interest on the loan from the warehouse manufacturer?
(b) What will the annual payments on the bank loan be?
(c) What is the annual rate of interest for the term loan from the finance broker?
(d) Based on cost considerations only, which source of financing should Temple select?
Textbook - Financial Management Principles and applications, 6th edition- https://www.dropbox.com/s/if3403cbexgrq8p/Financial%20Management_%20Principle%20-%20J%20William%20Petty.pdf?dl=0