Question and answer type of problem
1 THE HONG KONG POLYTECHNIC UNIVERSITY SCHOOL OF ACCOUNTING AND FINANCE Take-home Final Examination (Open Book) Programme : BBA (Hons) in Accountancy BBA (Hons) in Accounting and Finance BBA (Hons) in Financial Services BBA (Hons) in Accountancy (mixed mode) BBA (Hons) in Management BBA (Hons) in Marketing BBA (Hons) in Global Supply Chain Management BBA (Hons) in International Shipping and Transport Logistics BSc (Hons) in Investment Science BSc (Hons) in Computing BE (Hons) in Mechanical Engineering BE (Hons) in Electrical Engineering BE (Hons) in Electronic and Information Engineering Subject : Business Finance (AF3313) Time released : April 22 @ 8:30 AM Deadline: April 23 @ 6:00 PM Session : 2021/2022 (Semester TWO) This question paper has 8 printed pages (including this page) with 5 problems. POINTS TO READ BEFORE YOU START Answer ALL questions in separate sheets of paper or type your solution in one single file. Formula Sheet is on the last page of the question paper. EMAIL your solution (in PDF format) to your TUTOR and cc yourself a copy as proof of submission. Attach your signed Honour Declaration Form in the email to your tutor. DO NOT SEND THE SOLUTION TO YOUR LECTURERS!! 2 Question 1 (20 points) Part A (15 points) Transbot Inc., an all-equity financed company, is a manufacturer whose core operation is the production of robotic machines and transports. The CFO of the company is contemplating investing in two independent projects. The first project, RoboTrain is the production of robotic trains used in upscale shopping and leisure complex for carrying patrons within the facility. The second project, RoboMaid is the production of robotic maids used to gradually replace human domestic helpers. The CFO of Transbot hires you to perform relevant financial analyses and determine the feasibility of these projects. Based on estimates provided by your assistant, the expected return and standard deviation for RoboTrain are computed to be 16% and 12%, respectively and for RoboMaid 18% and 15%, respectively for the upcoming year. The correlation between the two projects is estimated to be 0.35. The stock returns for Transbot and the market (S&P 500 index) for the past 5 years are presented to you by your assistant as follows: Year Transbot’s stock returns Market returns 2017 28% 12% 2018 12% 11% 2019 27% 17% 2020 11% 12% 2021 15% 9% Assume the Capital Asset Pricing Model (CAPM) is valid and the firm beta is expected to remain unchanged in the foreseeable future. 3 Required a) Calculate the mean return and standard deviation for Transbot’s stock returns. (4 points) b) Determine the stock beta for Transbot. (3 points) c) What are the expected return and standard deviation of an equally-weighted portfolio consisting of RoboTrain and RoboMaid? Do you see any benefit from diversification? Explain in one or two sentences. (3 points) d) i) Your beta estimate for RoboTrain and RoboMaid are 1.52 and 1.65, respectively. What are the expected returns for RoboTrain and RoboMaid for the upcoming year according to CAPM? Assume the market risk premium to be 7% and the risk-free rate to be 4%. (4 points) ii) Would you advise your CFO to proceed with these investments? Is it appropriate to use the firm’s hurdle rate as benchmark comparison when making your decision? Explain your answer. (1 point) Part B (5 points; 1 point each) Suppose there are only three assets (A, B, and C) in a market. Given the following information: Asset Market Value Expected Return Standard Deviation Correlation with market portfolio Beta A $1,000,000 (i) 50% 0.3 2.9 B $2,000,000 8% 15% (iv) 1.05 C $2,000,000 3% 0% 0 (v) Market $5,000,000 15% (ii) 1 (iii) Fill in the missing values in the table. 4 Question 2 (20 points) Part A (12 points) The Smith Company has 10,000 bonds outstanding. The bonds are selling at 102% of face value, have a 8% coupon rate, pay interest annually, mature in 10 years, have a face value of $1000 and its yield to maturity is 7.7%. There are 500,000 shares of preferred stock outstanding with a current market price of $91 and pay annual dividend of $9. In addition, there are 1.25 million shares of common stock outstanding with a market price of $64 a share and a beta of .95. The most recent dividend paid by the company on the common stock was of $1.10 and it expects to increase those dividends by 3% annually forever. The firm's marginal tax rate is 35%. The overall stock market is yielding 12% and the Treasury bill rate is 3.5%. Required a. What is the cost of equity based on the dividend growth model? (3 points) b. What is the cost of equity based on the security market line? (3 points) c. What market weights should be given to the various capital components in the weighted average cost of capital computation? (3 points) d. What is the weighted average cost of capital using the cost equity calculated based on CAPM? (3 points) Part B (8 points) Storico Co. just paid a dividend of €5.20 per share. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth, after which the company will keep a constant growth rate forever. If the required return on Storico stock is 13 percent, what will a share of stock sell for today? 5 Question 3 (20 points) Daryl wishes to save money to provide for his retirement. He is now 30 years old and will be retiring at age 64. Beginning one month from now, he will begin depositing a fixed amount into a retirement savings account that will earn 12% compounded monthly. Then one year after making his final deposit, he will withdraw $100,000 annually for 25 years. In addition, and after he passes away (assuming he lives 25 years after retirement) he wishes to leave in the fund a sum worth $1,000,000 to his nephew who is under his charge. The fund will continue to earn 12% compounded monthly. How much should the monthly deposits be for his retirement plan? 6 Question 4 (20 points) Part A (10 points) Headquartered in Toronto, Canada, Toronto Royal Estate Inc. is an expanding real estate agency with presence all over Ontario, Alberta, and British Columbia. The company expects to earn $71 million per year in perpetuity if it does not undertake any new projects. The firm has an opportunity to invest $16 million today and $5 million in one year in real estate. The new investment will generate annual earnings of $11 million in perpetuity, beginning two years from today. The firm has 15 million shares of common stock outstanding, and the required rate of return on the stock is 12 percent. Land investments are not depreciable. Ignore taxes. Required a. What is the price of a share of stock if the firm does not undertake the new investment? (4 points) b. What is the value of the investment? (4 points) c. What is the per-share stock price if the firm undertakes the investment? (2 points) Part B (10 points) Sinbad Co. Ltd. is a company specializing in the production of high-end yachts for the billionaires. In order to expand its business, Sinbad wants to raise further debt capital and is about to issue 300,000 20-year bonds with 5% annual coupons and a face value of $1,000 each. A similar issue already outstanding is a par-value bond that offers a 6% annual coupon with the same face value. One year later, the market yield for this new bond has dropped by 1 percentage point. Required a. At what price should Sinbad sell its new bonds (at time 0)? (5 points) b. Compute the realized yield over this one year holding period. (5 points) 7 Question 5 (20 points) P&K Co. is contemplating investing in a new product. This project costs $18 million to start and it will be depreciated to zero over its life of 3 years. The project will immediately lower the firm’s net working capital by $1 million and such cost will be replaced at the end of the project’s life. The project will have no salvage value after 3 years. Net income of $15 million is expected to be earned annually over the life of the project. All revenues and costs will be received and paid in cash throughout the life of the project. The company is debt-free and is taxed at the 40% bracket. The appropriate discount rate is 10%. In the table below, indicate the amount of cash inflows (+ ve) or outflows (- ve) for the items in each period and calculate the NPV. Reproduce the same table in the answer booklet. Mark “0” if the cash flow is zero. Show your steps for the NPV calculation. Year 0 Year 1 Year 2 Year 3 Net Capital Spending Operating Cash Flow Net Working Capital Net Present Value 8 Beta of stock i i = (i,m)(i) / m