MAF603 – JAN 2018

SUGGESTED SOLUTION

QUESTION 1

a. Calculate the expected return and standard deviation of each security.

Expected Return
Eastern Bhd = 0.3 (20) + 0.3 (20) + 0.4 (29) = 23.6%

Western Bhd = 0.3 (25) + 0.3 (20) + 0.4 (10) = 17.5 %

Standard Deviation
___________________________________________
Eastern Bhd = 0.3 (20 – 23.6)2 + 0.3 (20 – 23.6)2 + 0.4 (29– 23.6)2
_____
= 19.44
= 4.41%

___________________________________________
Western Bhd = 0.3 (25 – 17.5)2 + 0.3 (20 – 17.5)2 + 0.4 (10– 17.5)2
_____
= 41.25
= 6.42 %
(12 x ½ = 6 marks)

b. Expected Return and Standard Deviation of Portfolio

Expected Return (Portfolio)

Portfolio = 0.8 (23.6) + 0.2 (17.5)

= 22.38%

Standard Deviation (Portfolio)

Portfolio = 0.82 (4.41)2 + 0.22 (6.42)2 + 2 (0.8) (0.2)(-0.95 x 4.41 x 6.42)

_____
= 5.489
= 2.34 %
(8 x ½ = 4 marks)

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c. Evaluate two investment that should be undertaken by En. Azman:

Investment Return Std Deviation

100% in Eastern Bhd 23.6% 4.41%
100% in Western Bhd 17.5% 6.42%
Portfolio 22.38% 2.34%

En. Azman should invest 100% in Eastern Bhd security and the portfolio . This is because
both investment offer higher return with lower risk as compared to investment of 100% in
Western Bhd security as it has higher risk with low return.
(3 x 1 = 3 marks)

d.
Investment Expected Return Required return Evaluation
100% in Eastern Bhd 23.6 % 13.6 % Underpriced
Portfolio 22.38 % 14.4 % Underpriced

Required return (Eastern Bhd)

RE = RF + β (RM – RF)
= 4% + 1.2 (12% - 4%)
= 13.6 %

Required return (Portfolio)

Rp = RF + β (RM – RF)
= 4% + 1.3 (12% - 4%)
= 14.4 %

Βp = 0.8(1.20) + 0.2(1.5)
= 1.3

Both 100% investment in Eastern Bhd and the portfolio are underpriced. This is because the
required return is lower than the expected return.

(10 x ½ = 5 marks)

e. The investor would like a portfolio with a higher expected return and a lower standard
deviation (risk averse investors).
(2 x 1 = 2 marks)
(Total = 20 marks)

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QUESTION 2

a.. i. The value of the company:

In a world without tax, VL = VU

VU = EBIT/Ro

= RM800,000/0.16 = RM5,000,000

ii. Value of equity

VL = S + B

RM5,000,000 = S + RM650,000

S = RM5,000,000 – RM650,000 = RM4,350,000

iii. Rs = Ro + B/S(Ro – RB)

= 16% + [RM0.65m/RM4.35m] [16% - 12%]

= 16.60%

iv. Share price = Value of equity / Number of shares

= RM4.35 m / 5 m
= RM0.87 per share
(10 x ½ = 5 marks)

b. i. The value of the company:

VL = EBIT(1 – T)/Ro + TcB
= RM800,000 (0.75)/0.16 + 0.25 (RM650,000 + RM100,000)
= RM3,937,500

ii. Rs = Ro + B/S(1 – tc)(Ro – RB)

= 16% + [RM0.75m/RM3.1875m] [1- 0.25] [16% - 12%]
= 16.70%

iii. The new market price of the company’s share:

= [RM3,937,500 – RM750,000]/3,000,000 share
= RM1.0625 per share

iv. RWACC = EBIT (1 – Tc)/VL

= RM800,000 (0.75) /RM3,937,500
= 15.24%

OR

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RWACC = B/V (RB) (1 – TC) + S/V (RS)

= 0.75/3.9375 (12%) (0.75) + 3.1875/3.9375 (16.70%)

= 15.24%

(20 x ½ = 10 marks)

c. In a world with taxes, the increase in the level of debt will increase the value of the firm
due to the increase in the tax shield . The capital structure taht maximizes firm value is
also the one that most benefits the interest of the stockholders. This result implies that
Majestic should have a capital structure almost entirely composed of debt.

(5 x 1 = 5 marks)
(Total: 20 marks)

QUESTION 3

a) Analyze the extract data in the two (2) proposals above using the Adjusted Present
Value (APV) method.

Alternative 1

APV = NPV (Base Case) – Net Processing Loan Fee + NPV (Loan)

NPV(BC) = -Initial Outlay + PV depreciation tax shield + PV after tax net revenue + PV Salvage Value

-Initial Outlay
Purchase Price 120,000 x 2 = 240,000 
Transportation 7,000 
GST and Import Duties 10,000 
Cost of machines (257,000)

PV of depreciation tax shield

  
(257,000-40,000) x 0.25 x (A5%, 5years = 4.3295) = 46,975.08
5 years
  
PV of after tax net revenue = 62,560 (0.75) (A14%, 5 years =3.4331) = 161,081.05
 
PV Salvage Value = 40,000 (P 14%, year 5 = 0.5194) = 20,776

= -RM257,000 + RM46,975,08 + RM161,081.05 + 20,776

= -RM28,167.87

-
NPF = Processing Loan Fee + PV annual tax shield

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 
Processing loan fee = 2% X RM257,000 = RM5,140
  
PV of annual tax shield = RM5,140 x 0.25 x (P5%, year 1 = 0.9524) = RM1,223.83

= -RM5,140 + RM1,223.83

= -RM3,916.17

NPV(LOAN) = Proceed of Loan Amount – PV of after tax interest – PV of principal repayment

Proceed of Loan Amount = RM257,000

   
PV of after tax interest = 0.09 x RM257,000 x 0.75 x (A 9%, 5 years = 3.8897) = 67,476.57
 
PV of principal repayment = RM257,000 (P9%, year 5 = 0.6499) = 167,024.30

= RM257,000 – RM67,476.57 – RM167,024.30

= RM22,499.13

APV = -RM28,167.87 - RM3,916.17 + RM22,499.13 = -9,584.91

Alternative 2

APV = NPV (Base Case) + NPV (TPU)

NPV (TPU)
 
Proceed of Loan Amount = 120,000 x 2 = RM240,000
  
PV of after tax interest = 0.07 x RM240,000 x 0.75 x (A 9%, 5 years = 3.8897) = 49,010.22
 
PV of principal repayment = RM240,000 (P9%, year 5 = 0.6499) = 155,976

= RM240,000 – RM49,010.22 – RM155,976

= RM35,013.78

APV = -RM28,167.87 + RM35,013.78 = 6,845.91

(30 x ½ marks = 15 marks)

b) Meera Pewter Manufacturing Sdn Bhd should continue to purchase both new digital
machines.  The best financing option is alternative 2 because the APV is positive and

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higher  amounting to RM6,845.91 than APV alternative 1 which is negative of

RM9,584.91.

(3 x 1 = 3 marks)

c) Advantages of using sensitivity analysis: (Any 2)

1. Sensitivity analysis shows NPV under varying assumptions, giving managers a

better feel for the project’s risks.

2. It reduces the false sense of security. It shows calculation for all

possibilities/expectations of a single variable.

3. When the error in the estimate on revenues or costs appear, sensitivity analysis
shows where more information about the factors determining revenues or costs
might be needed.

Or any other posssible answers.

(Any 2 points x 1 = 2 marks)
(Total: 20 marks)
QUESTION 4

a. Synergy: = VAB – (VA + VB)

= RM28.5m – [((RM3 x 2.5) x 0.6 m) + ((RM1 x 5) x 0.4 m]
= RM22 million

(4 x ½ = 2 marks)

b. i. NPV = Value of Twillight to Rainbow – Cost

(VB before merger + Synergy) – Cost
= [(RM2 m + RM22 m] – (RM11 x 0.4 m)
= RM19.6 million

ii.. NPV = Value of Twillight to Rainbow – ((new/(new + old) x VAB))

(VB before merger + Synergy) – Cost
= [(RM2 m + RM22 m] – (0.24 m /0.6 m + 0.24 m) x 28.5 m)
= RM15.86 million

(8 x 1 = 8 marks)

c. Rainbow Bhd should proceed with the acquisition because the NPV is positive.
(2 x 1 = 2 marks)

d. Choose alternative (i) acquisition by cash because the NPV is positive and higher.

(3 x 1 = 3 marks)

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e. Reasons why diversification is not a good reason to justify merger (Any 2)

i. Merger is a costly process (purchase above market price)
ii. Diversification can only eliminate part of the risk (unsystematic).
iii. The systematic risk will remain unchanged. Shareholders can diversify more
easily and cheaply by buying stocks in other companies or using mutual fund.
iv. There are risks of post merger such as intergation issues, employees motivation
and etc.
v. Any possible answers.
(Any 2 points x ½ = 1 mark)
(Explanation x 1 = 2 marks)

f. In a stock merger, the merger losses will be shared betwwen the shareholders of both
the acquiring and target firms based on their percentage shareholding.

In a cash merger, the merger losses will not be shared. The losses will be borne by the
original shareholders of acquiring firm.

(2 points with explanation x 1 = 2 marks)

(Total: 20 marks)

QUESTION 5

a. Two (2) ways to manage the short term exposure:

i. By entering into a forwad exchange agreement to lock in an exchange rate.

ii. By borrowing the dollar today, covert into euros and invest the euros for 60 days
to earn some interest.

(2 points x 1 = 2 marks)

b. Factors that influence exchange rate are:

i. Differentials in inflation. A country with a lower inflation rate will cause a rise in
currency value and vice versa.

ii. Differentials in interest rate. Higher interest rates will cause a rise in currency
value as higher interest offers lenders a higher return relative to other countries.

(2 points x 1 = 2 marks)
(Explanation x ½ = 1 mark)
c.
1.F
2.T
3.T
4.F
5.T

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(5 x 1= 5 marks)

d. Two (2) types of test of semi strong form. (Any 1)

i. Event studies - are statistical studies that examine whether the release of
information influences returns on other days. According to the efficient market
hypothesis, the return in any time periodis related only to the information released
during that period. Any information released before then should have no effect on
return because all of its influence would already have incorporated in the prices.

ii. The record of mutual funds - refers to studies comparing mutual fund performance
against the performance of a broad based index. Research findings found that
mutual funds were unable to beat the market index consistently since mutual fund
managers use publicly available information. Therefore, it is consistent with semi-
strong form efficiency.

(Any 1 point x 1 = 1 marks)

(Explanation x 2 = 2 marks)

e.
i. An efficient market is one in which stock prices fully reflect available information.
Therefore, in effecient market stock prices should immediately and fully rise to reflect
the announcement. This implies that it is almost impossible for investors to beat the
market and should only earn a normal profit.

Meanwhile, if the market is considered as inefficient, the stock prices do not adjust
immediately but are delayed to reflect available information. Therefore, there is an
opportuinity to make abnormal profit by buying the undervalued stock before the
market realizes it true value.

(5 x 1= 5 marks)

ii. As there is no opportuinity to make abnormal profits by relying on announcement

made by the company concerned, thus the immediate rise in price after
announcement is consistent with semi strong form of market efficiency.

(2 x 1= 2 marks)

END OF SOLUTION