Solution MAF603 - JAN 2018 without tick PDF

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SUGGESTED SOLUTIONQUESTION 1a. Calculate the expected return and standard deviation of each security.Expected Return Eastern Bhd = 0 (20) + 0 (20) + 0 (29) = 2 3 %Western Bhd = 0 (25) + 0 (20) + 0 (10) = 17 %Standard Deviation ___________________________________________ Eastern Bhd = 0 (20 – 23) 2 +...

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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

= = =

Western Bhd = = =

___________________________________________ 0.3 (20 – 23.6)2 + 0.3 (20 – 23.6)2 + 0.4 (29– 23.6)2 _____ 19.44 4.41% ___________________________________________ 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)

1

MAF603 – JAN 2018 c. Evaluate two investment that should be undertaken by En. Azman: Investment 100% in Eastern Bhd 100% in Western Bhd Portfolio

Return 23.6% 17.5% 22.38%

Std Deviation 4.41% 6.42% 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 100% in Eastern Bhd Portfolio

Expected Return 23.6 % 22.38 %

Required return 13.6 % 14.4 %

Evaluation Underpriced 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)

2

MAF603 – JAN 2018 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.

iii.

iv.

Rs = Ro + B/S(1 – tc)(Ro – RB) = 16% + [RM0.75m/RM3.1875m] [1- 0.25] [16% - 12%] = 16.70% The new market price of the company’s share: = [RM3,937,500 – RM750,000]/3,000,000 share = RM1.0625 per share RWACC = EBIT (1 – Tc)/VL = RM800,000 (0.75) /RM3,937,500 = 15.24% OR

3

MAF603 – JAN 2018 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 Transportation GST and Import Duties Cost of machines

120,000 x 2

PV of depreciation tax shield 



=

240,000  7,000  10,000  (257,000)



(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 



4

MAF603 – JAN 2018 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 higher  amounting to RM6,845.91 than APV alternative 1 which is negative of RM9,584.91.

5

MAF603 – JAN 2018 (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

= = =

ii.. NPV

= = =

Value of Twillight to Rainbow – Cost (VB before merger + Synergy) – Cost [(RM2 m + RM22 m] – (RM11 x 0.4 m) RM19.6 million

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)

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). 6

MAF603 – JAN 2018 iii. iv. v.

f.

The systematic risk will remain unchanged. Shareholders can diversify more easily and cheaply by buying stocks in other companies or using mutual fund. There are risks of post merger such as intergation issues, employees motivation and etc. Any possible answers. (Any 2 points x ½ = 1 mark) (Explanation x 1 = 2 marks)

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 (5 x 1= 5 marks) d.

Two (2) types of test of semi strong form. (Any 1) 7

MAF603 – JAN 2018 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 semistrong 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

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