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The University of Nottingham

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 No. of

shares

Beta Share price

(RM)

Market

Value (RM)

x Beta

Weighted

Beta

GENM 20,000 1.3 2.80 56,000 0.03

KLK 100,000 1.6 10.50 1,050,000 0.64

BJG 50,000 1.1 1.20 60,000 0.03

HLB 120,000 0.8 7.20 864,000 0.26

DIKI 110,000 0.9 5.50 605,000 0.21

2,635,000 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 withexpected returns. Shares with expected returns less then those predicted by these betas are

over priced and should be disposed of.

Company Beta Required

rate of

return

Expected

return

Value Advice

GENM 1.3 17.8 15 Overvalued Sell

KLK 1.6 20 20 Fairly

valued

Hold

BJG 1.1 16.3 18 Undervalued Buy

HLB 0.8 14 12 Overvalued Sell

DIKI 0.9 14.75 16 Undervalued Buy

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1 (ii)

a. Beta for precious metal fund = [correlation (previous metal fund, Nationalfund) x volatility of precious metal fund ] /

volatility of national fund

= 0.5 x 0.3 / 0.25

= 0.60

b. The required rate of return = 5% + 0.6 [ 15 5]

= 11%

Question 2( I )We will calculate cash flows as if there were no debt. Earnings Before Taxes (EBT below), is

calculated as Revenues-Costs-Depreciation. Net Income=EBT-Taxes=EBT(.66). Cash Flow=Net

Income + Depreciation.

The following numbers are in millions.

Year 1 2 3 4 5

Revenue 5 7.5 9 10 10.5

- Costs 4 5.5 6.2 6.8 7.2

- Written-down

allowance/depreciation

4 4 4 4 4

EBT - 3 -2 - 1.2 - 0.8 - 0.7

Taxes/ (rebate)

1.02 0.68 0.408 0.272 0.238

Profit after tax - 1.98 - 1.32 - 0.792 - 0.528 - 0.462

Written

allowance/

depreciation4 4 4 4 4

Cash flow 2.02 2.68 3.208 3.472 3.538

Cash flows will remain at RM3.538 million beyond year 5.

Discounting for APV requires an unlevered rate of return on the project, which can be calculated

using the project beta (assume that this the asset beta):

1.1*3.8% + 4.5% = 8.68%.

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-Then the terminal value at year 5 is 3.538 / .0868 = RM40.76 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, and subtracting the

initial investment,

NPV =(2.02/1.0868)+(2.68/1.0868^2)+(3.208/1.0868^3)+(3.472/1.0868^4)+(3.538/1.0868^5)+(40.76/1.0868^5) Initial investment (5 D + 15 E)

leads to an NPV of all-equity financed project of RM18.333 million.

-The tax shields are RM5 million *.34*.045 = RM76,500 for years 1 through 5 and RM7 million

*.34 *.045 = RM107,100 per year beyond year 5.

-Discounting the post-year 5 tax shields at the risk-free rate, we get the present value of the

perpetuity Interest payment (we are back to ): RM7 mill x 0.34 x 0.045 / 0.045= RM7 million * .

34 = RM2.38 million as a year 5 terminal tax shield value. So discounting a 5 year annuity of

76,500 at 4.5% and adding the present value of RM2.38 million, we obtain RM2.246 million asthe present value of all future tax shields.

Finally, RM18.333 million + RM2.246 million = RM20.58 million APV

( ii ). In case 1, 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). In this case,

the tax shield is less risky than the project, so it should be discounted at a lower rate.

In case 2, debt rises when equity rises, so tax shields are also positively related to equity.Then if equity has positive market risk, so do the tax shields. This case results in a higher

discount rate for the tax shields and a lower value.

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Question 3

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a. -12.5 + 1.2m (PVIFA12, 12%) = -12.5m + 1.2 (6.8109)

= -RM4,326,963

b. -12.5m + 2.2m (6.8109) = RM2,483,980

c. If they proceed with the project today, the projects expected NPV = (0.4 -RM4,326,963) + (0.6 RM2,483,980) = -RM240,397. So, TH Corporationwould not do it.

d. Since the projects NPV with the tax is negative, if the tax were imposed thefirm would abandon the project. Thus, the decision tree looks like this:

NPV @0 1 2 15 Yr. 0

40% Prob. | | | |

Taxes -12,500,000 12,000,000 0 0 -RM1,785,714

No Taxes | | | |60% Prob. -12.500,000 2,200,000 2,200,000 2,200,000 2,483,980

Expected NPV RM 776,102

Yes, the existence of the abandonment option changes the expected NPV of theproject from negative to positive. Given this option the firm would take on theproject because its expected NPV is RM776,102

e. NPV @0 1 Yr. 0

40% Prob. | |Taxes NPV = ? -3,000,000 RM

0.00+600,000 = NPV @ t = 1

No Taxes | |60% Prob. NPV = ? -3,000,000 2,678,571

+6,000,000 = NPV @ t = 1Expected NPVRM1,607,142

If the firm pays RM1,607,142 for the option to purchase the land, then the NPVof the project is exactly equal to zero. So the firm would not pay any more thanthis for the option.

5

r= 12%

r = 12%

}wouldnt do