MA514 Business Finance Major Case Study Assessment Questions Answers

Assessment Task Instructions

This is a Major Case Study Assessment equivalent to a Final Examination.

You are required to complete the following assessment task individually.

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Practice with the weekly tutorial questions.

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Case Study 1          (Total = 7 + 10 + 8 = 25 Marks)

The time value of money

Mark Harry, the owner of Blue Line fishing Boat Ltd was impressed by the work you had done on financial planning. Using your analysis, and looking at the demand for recreational fishing boats, he has decided that his existing fabrication equipment is sufficient, but it is time to acquire a bigger manufacturing facility. Mark has identified a suitable structure that is currently for sale, and he believes he can buy and refurbish it for about $100 000. Mark met Kristina, loan officer for Ace Bank to discuss the loan available to the company to finance this facility.

Kristina begins the meeting by discussing a 4-year loan. The loan would be repaid in equal monthly instalments.  Kristina stated that the compounding interest rate or Annual percentage rate of the loan would be 6% and our bank does not apply simple interest rate for loans.

However, Mark is confused as to how to calculate the equal monthly installments for the loan and the difference between compounding interest rate and simple interest rate.

Required Questions:

Provide Mark with advice on the following issues that are confusing him.

1. How to calculate the monthly loan installment at 6% Annual percentage rate?      (7marks)

Answer:

The monthly loan installment can be calculated using the  excel spreadsheet.

The formula for that is PMT

The PV = $100,000

FV = $0 as the loan will be paid completely

No of installments = 12 *4 years = 48 

Compounding interest rate or APR = 6%

Monthly rate = 6/12 = .05%

2. What will Mark’s monthly payments be?    (10marks)

Answer:

Marks Monthly payments are $5531.84

PMT(0.50,48,100000,0)

It is assumed that the installment is paid at the end of the period.

3. Compare and contrast difference between compounding interest rate and simple interest rate.       (8marks)

Answer:

 In compounding rate of interest and the simple interest rate are the methods of charging interest on a loan or borrowing. In simple rate of interest, the interest is charged at the fixed rate on the principle amount of loan or borrowing for the whole loan period., Thus the amount of interest is same in every year.

In compound interest the interest is charged on the interest for the previous period plus the principle amount at the beginning of the period. Thus the compound interest keeps on increasing very year on the amount of interest of the previous period. 

Thus for the same interest rate the compound interest results in more interest as compared to the simple interest. 

Case Study 2                  (Total = 5 + 5 + 5 + 10 = 25 Marks)

Interest rates, bills, and bond valuation

George and Dunolly are a high-income couple who believe that the Australian government bond is risk-free. They highly trust that investment in the capital market is risky and they have no intention to invest in the share market because they are risk-averse investors. Peter, one of George’s friends, told him that he is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. George decides to invest $200,000 in an investment bond in George's name, and visited you to obtain investment advice concerning a recently announced Treasury bond issue. Treasury has 7% coupon bonds on the market that have 13 years left to maturity. The bonds make annual payments and have face value of $1000. The yield to maturity (YTM) is 8.4%.

Required Questions:

Provide advice on the following issues:

1. Explain the difference between coupon rate and the YTM on a bond.      (5 marks)

Answer:

Coupon rate is the stated rate of interest which is payable on the bond. The coupon rate is paid on th efface value of the bond and is not affected by the market fluctuations. The coupon rate results in fixed cash flows to the investors. In the above given case, the coupon rate is &5. The face value of the bond is $1000. Thus the constant coupon payment on the bond is $1000*7% = $70

Yield to maturity is the market required rate of return for bonds of similar risk and maturity. This is the discount rate that is used to value a bond. This is the return to the investor if bond held to maturity also known as the internal rate of return on the bond. In the given case is YTM is 8.4% which is more than the coupon rate of 7%, thus the bond is selling at discount.

2. How does Treasury decide on the appropriate coupon rate to set on its bonds?     (5 marks)

Answer:

The prices of the T bills are determined based upon the level of risk the investors are eager to take.  The prices are determined at auctions which are conducted at various time intervals. The bidders for the bonds can be competitive bidders and non competitive bidders. The competitive bidders influence the discount rates and hence the price of the bonds.  The treasury accepts the price the competitive bidders are ready to pay at the descending order until all the bods are sold out. The inflation rate and affects the prices and hence the value of bonds.

3. Is it true that an Australian government bond is risk-free?     (5 marks)

Answer:

Australian government are considered as the safest bonds because the government has never defaulted on its bonds. The bonds are very less interest bearing because of the low risk they offer. Since the government has not defaulted and is not likely to default, they are nearly risk free and hence said so. Government bonds are considered as second lowest risk investment after cash. However, there is always some risks associated with the investments and that is there with government bonds also (Jolly, W., 2019). 

4. What is the current bond price of the above Treasury bond?    (10 marks)

Answer:

The current bond price is the discounted value of the cash flows discounted at YTM. 

C = coupon rate = 7% = 7*1000 = $70

r = YTM = 8.4%

F = Future face value = $1000

T = 13 years

= 70 *[ 1- (1/(1+.084)^13)]/.084 + 1000/[(1.084)^13] 

Bond Value = 541.30 +350.44 = $891.74

Equity markets and share valuation

Paul and Martin Constructions was founded 5 years ago by siblings Paul and Martin. The company constructs prestige homes in the Gold Coast region of Queensland.  Paul and Martin Constructions has experienced rapid growth because they provide high quality new homes at affordable prices. The company is equally owned by Paul and Martin. The original partnership agreement gave each sibling 50,000 shares.

Last year, Paul and Martin Constructions had earnings per share (EPS) of $3.15 and paid a dividend to Paul and Martin $45,000 each. The company also had a return on equity of 17%. The siblings believe that 15% is an appropriate required return for the company.

Required Questions:

Assuming the company continues its current growth rate, calculate the following:

1. Total earnings and dividend payout ratio.      (5marks)

Answer:

EPS = $3.15

Total Shares outstanding = 100,000

Total Earnings = 3.15 * 100,000 = $315,000

Total dividend paid = $45,000*2 = $90,000

Dividend Payout Ratio = Dividend Paid/ Total earnings =  $90,000/$315,000 = 28.57%

2. Retention ratio and share growth rate.      (5marks)

Answer:

Retention Ratio = 1- payout ratio = 1 – 28.57%

Retention ratio = 71.43%

  The dividend growth model makes the assumption that the share price will grow at the same constant rate as the dividend. What this means is that if the cash flows on an investment grow at a constant rate through time, the value of that investment grows at the same rate as the cash flows.

The share growth rate is 17%

3. Dividend paid last year.      (5marks)

Answer:

D₁ = dividend paid in current year

D₀ = dividend paid last year

G= growth rate = 15%

D₁ = D₀ (1+g)

90,000 = D₀ (1+15%)

D₀ = 90,000 / 1.15 = $78,260

Dividend paid last year = $78,260

4. What is the value per share of the company’s shares?      (5marks)

Answer:

Value per share = 

P0 = D0 (1 + g) / (R – g)

D0 = 90,000/100000 = $0.90

G = 15%

R = 17%

P0 = 0.90 *1.15/(17%-15%)

= $51.75

Current Price per share = $51.75

5. Why does the value of a share depend on dividends?      (5marks)

Answer:

The value of share depends upon Dividends because the value of any investment depends upon the future cash flows from the investments to the investor. In case of shares the cash flows are in the form of dividends. The increase in capital value of the share is realized only on sale of shares. The regular income is in the form of dividends. Therefore, the shares paying high dividends are valued higher. The value of shares depends upon dividends. 

Case Study 4        (Total = 3 + 3 + 8 + 3 + 5 + 3 = 25 Marks)

Glider East Gold Mines (GEGM) is evaluating its gold mine to include an underground mine. Dan Thompson, the company’s geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for five (5) years. Dan has taken an estimate of the gold deposit to Anna Karolin, the company’s financial manager. Anna has been asked by management to perform an analysis of the new mine and present her recommendation on whether the company should open it.

Anna’s estimates reveal that if the company opens the mine, it will cost $522 million today, while it will have a cash outflow of $40 million six (6) years from today in costs associated with closing the mine and restoring the mining site. The expected cash flows each year from the mine are shown in the table given below. GEGM has a 12% required return on all of its gold mines.

Required Questions:

1. What is the project payback period?      (3 marks)

Answer:

The payback period is the time that the project has recovered its initial investment.

During the fourth year, the cash flows from the project will be $131,000,000. So, the payback period will be 3 years, plus what we still need to make divided by what we will make during the third year. The payback period is:

 = 3 years + 130,000,000/ 261,000,000 = 3 + 0.50 = 3.5 years

Payback = 3.5 years

2. If it is company policy to reject projects with a payback period of longer than four years, should the company go ahead with the gold mine project?      (3 marks)

Answer:

The acceptance rule for payback period is to accept if the payback period is less than some preset limit. The payback period of Gold mine project is 3.5 years. The Payback period is less than 4 years which is the present limit for the company, therefore the company should go ahead with the Gold mine project on the basis of the payback period.

3. What is the net present value (NPV)for this project?     (8 marks)

Answer:

The NPV of a project is the PV of the outflows minus the PV of the inflows discounted @12%.

The NPV of the project is $16,233,650

4. If the company’s acceptance decision on this project is based on NPV, should this project be accepted? Why?    

Answer:

On the basis of NPV a project is accepted if the NPV is more than Zero. This will mean that the project is profitable and the project will result in net gain to shareholders wealth.  For the Gold mine project, the NPV is more than zero at $16,233,650. The project should be accepted.

5. What is the estimated internal rate of return (IRR) on this project? (Use an excel sheet if it is possible, otherwise provide an indication).     (5 marks)

Answer:

The IRR is the interest rate that makes the NPV of the project equal to zero. The equation for IRR for this project is:

0 = –$522,000,000 + $60,000,000/ (1 + IRR) + $140,000,000/ (1 + IRR)² + $192,000,000/ (1 + IRR)³   + $261,000,000/ (1 + IRR)⁴  + $160,000,000/ (1 + IRR)⁵  + -$40,000,000/ (1 + IRR)⁶

Using the excel spreadsheet:

IRR = 13.105%

6. If you apply the IRR decision rule, should this project be accepted? Why?      (3marks)

Answer:

The decision Rule for IRR is that accept the project if the IRR is greater than the required return. The IRR of the project is 13.105% and the required return for the company is 12%. Since IRR is more than the required return, the project should be accepted.