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TFIN603 Corporate Finance

Question 1 Total Marks: 25

You have recently been hired by Goff Telecommunications Testing Ltd (GTT). GTT was founded eight years ago by Chris Goff, and currently operates 74 units in the United Kingdom. GTT is privately owned by Chris and his family and had sales of $97 million last year.

GTT develops hardware/software solutions and test methodologies to help shorten customer product development cycles whilst reducing cost and risk. GTT’s growth to date has been financed from its profits. Whenever the company had sufficient capital, it would open a new unit. Relatively little formal analysis has been used in the capital budgeting process. Chris has just read about capital budgeting techniques and has come to you for help. The company has never attempted to determine its cost of capital, and Chris would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. You have determined that to estimate the cost of capital for GTT, you will use Spirent Communications plc as a representative company.

Using the information provided, answer the following questions:

  1. Since we are looking at Spirent Communications Plc to arrive at suitable values for Goff Technological Printing (GTP) what approach are we in essence undertaking? [10 marks]
  2. If Chris provides you with an estimated beta for Goff Technological Printing (GTP) of 1.2, the current risk- free rate is 4% and the return on the market is 9%, what would the expected return for GTP be? [10 marks]
  • In discussing cost of capital with Chris, he says from his reading on the internet that the cost of capital depends mainly on the source of funds and not the use of funds. Is this statement correct? [5 marks]

Type your answer here:

Question 2 Total Marks: 25

Hreon SA is an online technology company that provides services in outdated programming languages. As software upgrades, older languages such as VAX become obsolete. However, many organizations still have systems that use these languages and can’t afford to purchase completely new systems. This emerging sector is entering the growth phase of development and so Hreon is considering an increase in its capability effectiveness.

Since the firm has little free cash, it will need to borrow funds to support its investment. The problem facing Hreon is how much to borrow. The company has decided that an appropriate discount rate for its investment is 15 per cent and it wishes to increase its annual cash flows beginning one year from now by $250,000. Because of competition, it is not anticipated that the increased cash flows will last beyond ten years.

Using the information provided, answer the following questions:

  1. Hreon SA assumes that they will achieve an increase in cash flow of $250,000 for 10 years. Why is $250,000 in year 10 actually worth less than $250,000 in year 1? [10 marks]
  2. Hreon SA is assuming a discount rate of 15%. If they reassessed this and discovered that the discount rate should be 10%, what would this mean for the profitability of the investment? [10 marks]
  • Aside from the time value of money effect, what other factor influences how future cash flows are viewed? [5 marks]

Type your answer here:

Question 3 Total Marks: 30

You recently graduatedfrom university, and your job search led you to Coles Group Limited. Since you thought the company’s business was very promising, you accepted their job offer. As you are finishing your employment paperwork, Michel, who works in the Finance Department, stops by to inform you about the company’s new superannuation plan. Australian companies offer membership of a superannuation fund to their employees, where their Superannuation Guarantee contributions are saved.

Superannuation funds have concessional tax arrangements, which saves tax if you save for your retirement through your fund. So, if you can make contributions to the fund from your pre-tax income (known as salary sacrifice), contributions are deducted from your current salary, and no current income tax is paid on the money, and the super fund pays only15%tax on the contributions.For example, assume your salary will be$130 000per year. If you contribute$7200pre-tax to the superannuation fund, you will pay taxes on only$122 800in income. Taxes will be payable on the initial deposits at15%and on any capital gains or fund income while you are invested in the fund, and you will not pay taxes when you withdraw the money at retirement, provided you retire at or after turning 60. At Coles, you can contribute up to6%of your salary to the plan, which will be saved in the fund with your9%Superannuation Guarantee contributions.

The Coles superannuation fund has several options for investments, most of which are managed funds. As you know, a managed fund is usually made up of a portfolio of assets. When you purchase shares in a managed fund, you are actually purchasing partial ownership of the fund’s assets, similar to purchasing shares in a company. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee paid to the fund manager, which makes all of the investment decisions for the fund. Coles Group Limited uses Down Under Financial Services to manage its superannuation plan.

Michel then explains that the retirement investment options offered for employees are as follows:

Down Under All Ordinaries Index Fund.This fund tracks the All Ordinaries Index. Shares in the fund are weighted exactly the same as they are in the All Ordinaries Index. This means that the fund’s return is approximately the return of the All Ordinaries Index, minus expenses. With an index fund, the manager is not required to research shares and make investment decisions, so fund expenses are usually low. The Down Under All Ordinaries Index Fund charges expenses of0.20%of assets per year.

Down Under Property Trust Fund.This fund invests primarily in property trust shares. As such, the returns of the fund are slightly less volatile than the All Ordinaries Index. The fund can also invest10%of its assets in companies based outside Australia and New Zealand. This fund charges1.70%of assets in expenses per year.

Down Under Bond Fund.This fund invests in long-term corporate bonds issued by companies domiciled in Australia and New Zealand. The fund is restricted to investments in bonds with an investment grade credit rating. This fund charges1.40%in expenses.

Down Under Money Market Fund.This fund invests in high-quality debt instruments, which include bank bills and government bonds. As such, the return on money market funds is only slightly higher than the return on government bonds. Because of the credit quality and nature of the investments, there is only a very slight risk of negative return. The fund charges0.60%in expenses.

Using the information provided, answer the following questions:

  1. Assume you decide you should invest at least part of your money in an All Ordinaries Index fund of companies based in Australia. What are the advantages and disadvantages of choosing the All Ordinaries Index fund compared with the Bond Fund? [10 marks]
  2. The returns of the Down Under Property Trust Fund are less volatile than those of the All Ordinaries Index fund, but more volatile than the rest of the managed funds offered in the superannuation fund. Why would you ever want to invest in the Property Trust Fund? When you examine the expenses of the funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund? [10 marks]
  • A measure of risk-adjusted performance that is often used in practice is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviations and returns for the funds over the past 10 years are listed below. Assuming a risk-free rate of 4%, calculate the Sharpe ratio for each of these. In broad terms, what do you suppose the Sharpe ratio is intended to measure? [10 marks]

DOWN UNDER FUND

TEN-YEAR ANNUAL

STANDARD DEVIATION

All Ordinaries Index Fund

9.15%

19.35

Property Trust Fund

14.05

26.82

Bond Fund

9.53

23.82

Money Market Fund

8.73

11.45

Type your answer here:

Question 4 Total Marks: 20

Dick Davies, the owner of Davies Gold Mining, is evaluating a new gold mine in Tanzania. Barry Koch, the company's geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Barry has taken an estimate of the gold deposits to Andy Marshall, the company's financial officer. Andy has been asked by Dick to perform an analysis of the new mine and present his recommendation on whether the company should open the new mine.

Andy has used the estimates provided by Barry to determine the revenues that could be expected from the mine. He has also projected the expense of opening the mine, and the annual operating expenses. If the company opens the mine, it will cost $500 million today, and it will have a cash outflow of $80 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the following table. Davies Gold Mining has a 12 per cent required return on all of its gold mines.

Year

Cash flow ($)

0

-500,000,000

1

60,000,000

2

90,000,000

3

170,000,000

4

230,000,000

5

205,000,000

6

140,000,000

7

110,000,000

8

70,000,000

9

-80,000,000

Using the information provided, answer the following questions:

  1. Andy is asked by Dick to rank the different valuation methods by how appropriate they are for analysing the project. Rank the different methods used. [10 marks]
  2. In discussing the payback period rule Dick asks Andy to highlight its strengths and weaknesses. What are they? [5 marks]
  • In analysing the mine, Andy advises Dick that this mine is riskier than other mines in the Davies Gold Mining portfolio and so the discount rate should increase. Explain what impact will this have on the cash flows of the project. [5 marks]

Type your answer here:

______________________________

END OF THE EXAMINATION

I have solved only half of it, it is for question no. 3 and question no. 4

Answer I.

We need to calculate the coefficient of variation and the formula is as follows

= Standard Deviation / Mean * 100

Coefficient of variation for All Ordinaries Index Fund = 19.35/9.15 * 100

= 211.48%

Coefficient of variation for Bond Fund = 23.82/9.53 * 100 = 249.95 %

Advantage and Disadvantage of choosing the All Ordinaries Index Fund is as follows :

  1. As we are able to see from the data provided in the question as well as from the calculation of Coefficient of Variation we can see very easily that the return is bit lower than than the Bond Fund but the Standard Deviation of Bond Fund is much higher than the All ordinaries Index fund. The Coefficient of variation is also quit high is 249.95% compare to 211.48 % of all ordinaries index fund. Hence the Bond fund is more risky than the All ordinaries index fund .
  2. As we have seen from the basic characteristic of investment in the All Ordinaries index fund that the index is calculated on the basis of weighted average methods. Means that the fund’s return is approximately the return of all ordinaries Index minus Index. In this investment even the management need not spend much time on research the shares and the market and it is less risky also than the Investing into the long term corporate bond in Australia as well as new Zealand.
  3. When we see that fund manager charges it is also very low for the all ordinaries index funds compare to the bond funds . it is only 0.20 % compare to bind fund charges of 1.40% in expenses.

Hence by comparing all the above points we can make a conclusion that if we want to invest at least part of company we will be giving priorities into investing into All ordinaries index funds of companies based in Australia Over and above the investing into the bond fund of long term corporate bond issues by the companies domiciled in Australia as well as New Zealand.

Answer of II.

Calculation of coefficient of variation for all the fund investments .

DOWN UNDER FUND

TEN YEAR ANNUAL AVEARGE RETURNS

STANDARD DEVIATION

COEFFICIENT OF VARIATION =

SD/MEAN * 100

FUND MANAGEMENT EXPENSES

All ordinaries Index Fund

9.15

19.35

211.48 %

0.20 %

Property Trust Fund

14.05

26.82

190.89%

1.70 %

Bond Fund

9.53

23.82

249.95 %

1.40 %

Money Market Fund

8.73

11.45

131.15%

0.60 %

From the above table we are able to see that returns from Down Under property Trust fund are less volatile than the all ordinaries fund but more volatile than the Money market fund, It is also less volatile than the Bond funds. But we are able to see from the above calculation that property trust Fund return is highest among the all types of investment funds. It gives us all most 5 % approx. estra return than any other funds. It comes to almost increase in the returns of 50 % approx.. compare to all other funds. Yes together with the average return it standard deviation is highest among the all types of funds but when we have calculated the COEFFICIENT OF VARIATION, we found that its coefficient of variation is lesser than the ordinaries index fund as well as money market fund hence it is advisable into the property trust fund. The expenses of fund will not have any impact because when we calculate the returns it is deducted hence the rate of expenses will not have any impact of the decisions.

Solution Q no. 4

  1. Calculation of payback periods

Years/ Cash Flows

Cash Flows ( $)

Cumulative Cash Flows

0

-500,000,000

1

60,000,000

60,000,000

2

90,000,000

150,000,000

3

170,000,000

320,000,000

4

230,000,000

5

205,000,000

6

140,000,000

7

110,000,000

8

70,000,000

9

-80,000,000

In the fourth year we need additional cash flow for pay back period

= $ 500,000,000 – $ 320,000,000 = $ 180,000,000

Pay Back Period = 3 years + 180,000,000/230,000,000

= 3 years + 0.783 years

= 3.783 years

= 3 years & 10 months approx..

  1. Net Present Value ( NPV) ( Amount in $)

Years/ Cash Flows

Cash Flows ( $)

Discounting

Factor @ 12 %

Present Value

0

-500,000,000

1.000

-500,000,000

1

60,000,000

0.893

53,580,000

2

90,000,000

0.797

71,730,000

3

170,000,000

0.712

121,040,000

4

230,000,000

0.636

146,280,000

5

205,000,000

0.567

116,235,000

6

140,000,000

0.507

70,980,000

7

110,000,000

0.452

49,720,000

8

70,000,000

0.404

28,280,000

9

-80,000,000

0.361

-28,880,000

NPV

133,965,000

  1. Calculation of IRR ( Amount in $)

Years/ Cash Flows

Cash Flows ( $)

Discounting

Factor @ 15 %

Present Value

0

-500,000,000

1.000

-500,000,000

1

60,000,000

0.870

52,200,000

2

90,000,000

0.756

68040000

3

170,000,000

0.658

111860000

4

230,000,000

0.572

131560000

5

205,000,000

0.497

101885000

6

140,000,000

0.432

60480000

7

110,000,000

0.376

41360000

8

70,000,000

0.327

22890000

9

-80,000,000

0.284

-22720000

NPV

67555000

( Amount in $)

Years/ Cash Flows

Cash Flows ( $)

Discounting

Factor @ 20 %

Present Value

0

-500,000,000

1.000

-500,000,000

1

60,000,000

0.833

49980000

2

90,000,000

0.694

62460000

3

170,000,000

0.579

98430000

4

230,000,000

0.482

110860000

5

205,000,000

0.402

82410000

6

140,000,000

0.335

46900000

7

110,000,000

0.279

30690000

8

70,000,000

0.233

16310000

9

-80,000,000

0.194

-15520000

NPV

-17480000

At 15% our NPV = $ 67,555,000

At 20% our NPV = - $ 17,480,000

IRR = 15 % + 67,555,000/ 85035000* 5

= 15 + 4.96

= 19.96 %

Conclusion :

Our NPV @ 12 % = + $ 133,965,000

Our IRR = 19.96%

Our Pay Back Period Is = 3 years & 10 months

The life of the project is 8 years and pay back period is just 3 years & 10 months hence according to pay back period the project must be selected .

NPV = is + $ 133,965,000 so according to NPV project must be selected and it is advisable for Davies Gold Mining to invest into this projects.

IRR = 19.96% and it is much more than the cost of capital that is 12 % hence according to this approach the project must be selected.

Now comparing with all the tools we will rank first to IRR as it calculate the exact return of the project and give us the real picture of exact return. NPV is ranked second and Pay back period is ranked third as pay back period is not considering the future cash flows after the pay back period .

  1. In discussing the payback period Dick highlighted its strength and weakness which as follows.

Strength :

  1. Payback period is simple and easy to calculate .
  2. It gives us an indication of probability.
  3. In border sense , the payback period deals with the risk also. The project with a shorter period will be less risky than the project with a higher period.

Weakness:

  1. This method ignores all the cash flows which inflows after the payback period.
  2. It ignores the timing of the occurrence of the cash flows
  3. The pay back period also ignores the salvage value of the project.
  1. If the discount rate will increase than upto 19% it will have positive NPV but if it goes beyond the project will have negative NPV and the cost of capital will increase from its IRR and the project will become unviable. This is the suggestion give by Andy to Dick.
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