Question 1
Abigail Tan, aged 32, is a successful investment banker and one of the top experts in corporate merger and acquisition (M&A) in Asia. At the moment, Abigail has $8,000,000 in a savings account with Jubilee Bank and some bond investment worth $5,000,000 with Open Securities Ltd. She is now planning for retirement in eight years' time.
She intends to increase her retirement savings by depositing $30,000 at the end of every month in her savings account for the next five years and increase the amount up to $40,000 per month for the final three years until retirement. The savings account provides a 2.4% p.a. monthly compounded interest rate to Abigail, while the bond investment is expected to offer a 9% annual return to her.
Abigail believes she will live 30 years more after she retires. Once she is retired, she will put all her wealth into a retirement savings account with a 1.2% p.a. monthly compound interest rate. When she dies, Abigail would like to leave a lump sum of $4,000,000 to her nephew Brandon for his living expenses.
Answer the following questions:
a. How much will Abigail have at the end of eight years when she retires?
b. With $4,000,000 set aside for her nephew upon her death, how much can Abigail withdraw each month during her retirement?
c. Assume that Abigail would like to withdraw $70,000 each month after her retirement. In order to achieve this goal, she has to transfer part of the money from her savings account to bond investment at the beginning. What amount should Abigail transfer?
Question 2
Becky was just promoted to the senior position of Sales Director last month, and she is now considering driving to her office instead of being cramming inside the MTR compartment like a sardine every morning. She would like to buy a second-hand Mercedes-Benz E200 which costsabout $360,000. Open Finance quotes an interest rate of 6% p.a. for a 36-month loan loan with a 10% down payment. Becky plans on tradingthe car in for a new Tesla Model 3 in two years.
a. What will Becky's monthly payment be?
b. What are the amounts of interest, principal and ending balance in the first and second months? Please fill in the following table.
| Month |
Beginning balance |
Monthly payment |
Interest paid |
Principal paid |
Ending balance |
| 1 |
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| 2 |
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| total |
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c. Calculate the effective interest rate on the loan?
d. What will the loan balance be when she trades the car in at the end of second year?
Question 3
ABC Ltd has just paid a cash dividend of $10 per share to its shareholders. The dividend is expected to grow at a steady rate of 8% per year.
DEF Ltd also paid $10 of cash dividend to its shareholders. The dividend is expected to grow at 25% per year for the next five years and then settle down to 5% per year indefinitely.
JKL Ltd has a dividend payout ratio of 40%. Its expected earnings per share (EPS1) to be $8 at the end of the first year and the company has a 4% dividend growth rate.
Assume a 12% required rate of return on common stock for the three companies.
Answer the following questions:
a. What is the current stock price of ABC Ltd? What will the stock price be worth in five years?
b. Find out the expected dividend of DEF Ltd from year one to year five. What is the stock price of the company at the end of year five (P5)? Also, compute the current stock price (P0) of the company.
c. What is the current stock price and the expected price-earnings ratio (P/E1) of JKL Ltd?
Question 4
Your friend, Daisy, has presented the following information for two Hong Kong stocks to you:
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Stock
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Beta
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Expected return
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|
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J
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0.4
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6%
|
|
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K
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1.6
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18%
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The return of the Hang Seng Index (a good proxy of the market return) is currently 14% and the risk-free rate is 4%.
Answer the following questions:
a. She has asked you for help to construct an investment portfolio from the two stocks so that the portfolio beta (βp) will be 1.3. Advise Daisy on the allocation of the two stocks in order to achieve her objective.
b. Explain in details whether you should invest in Daisy's portfolio.
c. Refer to Unit 2, Figure 2.8 of the course material, and draw the security market line (SML) and plot Daisy's portfolio.
d. Comment on the following statements. If necessary, use mathematics to support your answers:
i. If the CAPM is valid, it is impossible to construct a portfolio of risky assets whose return is equal to the risk-free rate, unless the
portfolio only consists of risk-free assets.
i. If the CAPM is valid, you will have a portfolio's beta equal to 0.333 when you put $300,000 in the market portfolio and$100,000 in risk-free assets.
Question 5
Andrew is the production manager of Big Cauldron, one of the leading cast-iron casseroles manufacturers in the world. The marginal tax rate and the cost of capital of Big Cauldron is 25% and 12%, respectively.
Currently, Andrew is considering replacing the old foundry with a new one equipped with computer temperature controlled sensors (CTCS) to improve the firm's production quality. The old foundry was purchased six years ago with a total cost of $10,000,000. It has a ten-year economic life with zero salvage value, and four years remaining. The company uses a straight line depreciation method on all its production assets. If the old foundry were to be sold today, it would be worth $4,000,000.
The new foundry is proposed by Culinary Consulting, a well-known consulting firm in the food and beverage (F&B) industry. The purchase price of the proposed foundry would be $8,000,000. Also, Big Cauldron would have to incur $320,000 installation costs and $600,000 investment in net working capital (NWC). The economic life of the new foundry is four years, with zero scrap value. It is expected that the new foundry can reduce before-tax operating expenses by $1,700,000 every year. Big Cauldron has already paid $80,000 to Culinary Consulting to obtain the feasibility report regarding this replacement recommendation.
Answer the following questions:
a. What is the initial outlay associated with this proposed purchase?
b. What are the annual after-tax cash flows associated with this proposed purchase, for years 1-3? What is the amount of after-tax cash flow for the terminal in year 4?
c. Calculate the net present value (NPV) of this replacement decision. Would you accept or reject the use of the new foundry?
d. ‘A firm should not accept project with zero net present value.' Do you agree with this statement? Please explain.
Question 6
Cloud Investments is a private equity firm focusing on Internet of Thing (IoT) projects. The firm uses a 6% discount rate for its investments. The company is now considering choosing one IoT project among two candidates, code-named Project Hera and Project Zeus. The after-tax cash flows of the two projects are as follows:
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After-tax cash flows ($)
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Year
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Project Hera
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Project Zeus
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0
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-5,000,000
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-5,000,000
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1
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2,400,000
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2,800,000
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2
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2,000,000
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3,000,000
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3
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1,600,000
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Answer the following questions:
a. If Cloud Investments uses the net present value (NPV) method, which project would it choose?
b. Would the decision be the same if the replacement chain method was used? Show your calculation.
c. Would the decision be different from (b) if the equivalent annual annuity (EAA) method was used? Show your calculation.
d. Based on your answers in parts (a), (b) and (c), how should Cloud Investments choose? Provide one assumption on the replacement chain method and EAA method, respectively, to enable the two methods to assess unequal live, mutually exclusive, projects.
Question 7
Eastern Digital Technology (Eastern Digital) is a leading hard disk drive (HDD) manufacturer in Asia. The company wants to acquire Sand Disk Corporation (Sand Disk), a fast growing solid-state drive (SSD) producer in Asia. The management of Eastern Digital believes that acquiring Sand Disk can bring handsome revenue to the company in future.
As a business analyst in the Eastern Digital, you have been asked by the board to determine an appropriate discount rate to evaluate the proposed acquisition. From your studies in FIN B280, you think the first step is to identify the Weighted Average Cost of Capital (WACC) of the target company. With some research, you have obtained the following capital structure information of Sand Disk:
Sand Disk Corporation Capital Structure Information:
i. 12,000,000 shares of common stock with a par value of $1.0, and a current price of $6 per share.
ii. 5,000,000 shares of 9% preferred stock with a par value of $4, and a current price of $4.80.
iii. 20,000 units of 5-years, 11.70% p.a. coupon bonds with semi-annual interest payment. The bond has exactly four years to maturity with a par value of $1,000. The current quotation of this bond is 120.00, which means 120% of its par value. Bonds with similar risk, interest term and maturity are currently selling at 6.00% p.a. yield to maturity.
iv. A $40,000,000 long-term bullet payment loan with Bank of Kennedy. The loan was borrowed eight months ago with a 4.3% p.a. borrowing rate. The market value of this bank loan is unknown.
v. The expected market return is 9% and the risk-free rate is 3%. The beta of Sand Disk's common stock is 1.5. The company falls into the 25% marginal tax bracket.
Answer the following questions:
a. What is the capital structure of Sand Disk on a market value basis? Please make assumptions in your calculation, if necessary.
b. Evaluate the weighted average cost of capital (WACC) of Sand Disk.
c. Given that the firm uses only debt and equity financing and further given that the risk of financing will be increased by increasing the financing amount, do you agree that an increase in debt financing will increase the overall risk of the firm (i.e. WACC or RA) and therefore decrease the value of the firm?
Question 8
Giant Corporation had exceptional earnings last year. The Chairman of the Board would like to share the good results with shareholders and is evaluating either paying extra cash dividend or repurchasing shares directly from the market. In either case, $20 million would be spent.
The company has 8 million shares outstanding. The EPS of Giant Corporation is $4 and the stock currently sells for $50 per share. Ignore taxes and other imperfections.
Answer the following questions:
a. Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholders' wealth.
b. What will be the effect on Giant Corporation's EPS and P/E ratio under the two different scenarios?
c. Under the condition of no tax and any imperfection:
From the shareholders' point of view, are you indifferent in choosing between the two scenarios? Why?
From Giant Corporation perspective, which of these actions would you recommend? Why?