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BUSINESS SCHOOL A LEVEL 2 MODULE, AUTUMN SEMESTER 2009-2010 FINANCIAL MANAGEMENT

Suggested Solution Question 1 (i) a. The portfolio beta is the weighted average of the individual security betas. Company GENM KLK BJG HLB DIKI No. of shares 20,000 100,000 50,000 120,000 110,000 Beta 1.3 1.6 1.1 0.8 0.9 Share price (RM) 2.80 10.50 1.20 7.20 5.50 Market Value (RM) x Beta 56,000 1,050,000 60,000 864,000 605,000 2,635,000 Weighted Beta 0.03 0.64 0.03 0.26 0.21 1.16

Since the portfolio beta is 1.16 and it is greater than 1, the portfolio is riskier than the market. b. To advise the company, we need to compare the returns predicted by the CAPM with expected returns. Shares with expected returns less then those predicted by these betas are over priced and should be disposed of. Company GENM KLK BJG HLB DIKI Beta 1.3 1.6 1.1 0.8 0.9 Required rate of return 17.8 20 16.3 14 14.75 Expected return 15 20 18 12 16 Value Overvalued Fairly valued Undervalued Overvalued Undervalued Advice Sell Hold Buy Sell Buy

1

02 2. is calculated as Revenues-Costs-Depreciation.98 .7 1.1.238 Taxes/ (rebate) Profit after tax .0.2 .2 . Discounting for APV requires an unlevered rate of return on the project.538 Cash flows will remain at RM3.8 . The required rate of return = = 0.272 0.32 . Year 1 2 3 4 5 Revenue 5 7.6 [ 15 – 5] 11% Question 2 (I) We will calculate cash flows as if there were no debt. Cash Flow=Net Income + Depreciation.0.68 0.472 3.5 6.408 0.25 = b.8 7. Earnings Before Taxes (EBT below).1*3.5 x 0.2 6.462 Written allowance/ 4 4 4 4 4 depreciation Cash flow 2.Costs 4 5.538 million beyond year 5.Writtendown 4 4 4 4 4 allowance/ depreciation EBT -3 -2 .5 .5% = 8.60 5% + 0.0. 2 .528 .1. Beta for precious metal fund = [correlation (previous metal fund.0.68 3. which can be calculated using the project beta (assume that this the asset beta): 1.3 / 0.02 0. Net Income=EBT-Taxes=EBT(.66). National fund) x volatility of precious metal fund ] / volatility of national fund = 0.208 3.0.8% + 4.1.792 .5 9 10 10. The following numbers are in millions.1 (ii) a.68%.

NPV =(2.333 million + RM2. so do the tax shields.5% and adding the present value of RM2.333 million.38 million.538 / . we obtain RM2. so tax shields are also positively related to equity.0868^5) – Initial investment (5 D + 15 E) leads to an NPV of all-equity financed project of RM18. In case 2.472/1.246 million = RM20. interest payments and tax shields are constant over time (except to the extent that default is possible or that the firm may have negative taxable income). debt rises when equity rises. we get the present value of the perpetuity Interest payment (we are back to ): RM7 mill x 0.538/1. So discounting a 5 year annuity of 76.500 at 4.045 = RM76.045 / 0.045 = RM107.045= RM7 million * . Finally.02/1.0868 = RM40. Then if equity has positive market risk. In this case. and subtracting the initial investment.68/1.0868^5)+(40. RM18. -Discounting the post-year 5 tax shields at the risk-free rate.208/1. so it should be discounted at a lower rate.76/1.34 x 0.34*. 3 .58 million APV ( ii ). -The tax shields are RM5 million *.0868^2)+(3.-Then the terminal value at year 5 is 3.0868^3)+(3.0868)+(2.0868^4) +(3.500 for years 1 through 5 and RM7 million *. 34 = RM2.34 *. the tax shield is less risky than the project. In case 1.76 million. (perpetuity b/c CFs beyond year 5 is the same as year 5CF) -Discounting this terminal value as well as the year 1 through 5 cash flows.100 per year beyond year 5.246 million as the present value of all future tax shields.38 million as a year 5 terminal tax shield value. This case results in a higher discount rate for the tax shields and a lower value.

Question 3 4 .

d.142 for the option to purchase the land.607.4 × -RM4.8109) = c.500. Taxes 0 = 12% r NPV = ? | 1 -3.980 b. Thus.000.326.714 40% Prob.000.142 NPV = ? | -3. the decision tree looks like this: 0 12% r= 1 2 0 | | ••• 1.8109) -RM4.980) = -RM240. Given this option the firm would take on the project because its expected NPV is RM776. So the firm would not pay any more than this for the option.000 = NPV @ t = 1 | NPV @ Yr.000 No Taxes | 60% Prob.000 +6.483.500.2 (6. Since the project’s NPV with the tax is negative.980 Expected NPV RM 776.000 ••• 2.000 2.200.5 + 1. -12.483.200.000.000 2.963 RM2.00 No Taxes 60% Prob. | | Taxes -12.483.5m + 1. RM1. 40% Prob.785. then the NPV of the project is exactly equal to zero.6 × RM2. 12%) = = -12. -12. the existence of the abandonment option changes the expected NPV of the project from negative to positive.102 e.a. -12. the project’s expected NPV = (0.397.200.963) + (0.000 | 15 0 | | NPV @ Yr. 0 -RM 2.326.000 = NPV @ t = 1Expected | 2.2m (6. if the tax were imposed the firm would abandon the project. TH Corporation would not do it. 5 .5m + 2. 0 }wouldn’t do RM 0.102 Yes. So.000 +600.000.000 12.678. If they proceed with the project today.2m (PVIFA12.607.571 NPV If the firm pays RM1.

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