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AF3313 Business Finance

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AF3313 Business Finance

AF3313

    Business Finance 

Semester 1 2019-2020 

Individual Take-home Assignment (REVISED) 

Points to note: 

1)     In light of the current situation, the School’s decision is that the final exam for this course will be replaced by this assignment. 

2)     Students should answer all 3 questions. Apart from knowledge acquired from this course, students may be expected to carry out further research to support their answers.

 3)     Students must type and submit their work via Turnitin. The similarity index should not exceed 30%. Length of essays should be within 2,000 words. There is no word limit on the numerical problems. Answers to all questions must be typed. 

4)     Citation of references is not required. 

5)     Send your typed work along with the Turnitin report to your OWN TUTOR. Be sure to send a carbon copy to yourself as evidence of submission. 

Tutor

 

Email

 

 

 

 

 

Alex WANG

 

alex.yi.wang@connect.polyu.hk

 

 

 

 

 

 

David DU

 

ddvdavid.du@connect.polyu.hk

 

 

 

 

 

Ross YANG

 

zhonghuag.yang@connect.polyu.hk

 

 

 

 

Xin YANG

 

xin.jx.yang@connect.polyu.hk

 

 

 

 

 

 

 6)     The deadline is Dec. 24, 2019 before 5pm. Late submission is NOT accepted. 

7)     No questions can be posed to any tutors/lecturers and students should not discuss these problems among themselves. Violation to this rule is considered cheating. 

8)     In the subject line of the email, clearly specify the Subject code & name, Tutorial number, your Name (Last then First), and Student ID.

Question 1 (30 marks) 

Choose TWO of the following independent essay topics. If you choose to do all three, only the first two essays written will be graded. 

A)  Provide a real life example of a long-term external source of finance used by a listed company in Hong Kong. Describe the nature of this financial arrangement (e.g. purpose, duration, risk assessment, etc.). In your opinion, explain whether this financial arrangement was a right move and suggest alternatives to this arrangement with reference to what you learned in this course and provide justifications. (15 marks) 

B)   Analyze why, despite employing various investment appraisal techniques, large investment projects in big corporations may fail to deliver their estimated cash flows. Critically assess how a failed capital project may affect key stakeholders and shareholder value, and also shape the future strategy of investment capital. (15 marks) 

C)   Critically analyze the merits and demerits of the Capital Asset Pricing Model (CAPM) and discuss its value in practice. (15 marks)

Question 2 (15 marks) 

Johnny Wellington, an entrepreneur who wants to engage in a short term business project, comes to you for advice. As an expert in capital budgeting, Johnny wants you to study the feasibility of the project. In particular, he needs your help to forecast the upcoming cash flows the project is going to require and generate throughout its life. After a few meetings with Johnny and his business partners, you suggest that a pilot run be conducted. 

Upon completion of the pilot run at the end of year 1, Johnny and his associates can choose either to continue with the project or terminate it. You forecast that this project will generate cash flows for 4 years after the pilot run if Johnny decides to further proceed. 

The pilot run costs $1.0 million to start and if they decide to continue with the project after this pilot run, an additional investment cost amounting to USD1.6 million will be incurred at the end of year 1. The investment cost of USD1.6 million will be fully depreciated on a straight line basis over the life of the project with no scrap value at the end. If the outcome from the pilot run is positive, Johnny can launch the project in full scale at the end of year 1. Revenues, variable costs and fixed costs for years 2 through 5 are estimated to be as follows:

 

Years 2-5

 

 

Revenues

USD 7 mil / year

 

 

Variable Costs

USD 3 mil / year

 

 

Fixed Costs

USD1.8 mil / year

 

 

  However, if the outcome from the pilot run is not encouraging and the team decides to launch the project in full scale, the following estimates are obtained: 

 

Years 2-5

 

 

Revenues

USD 4.05 mil / year

 

 

Variable Costs

USD 1.735 mil / year

 

 

Fixed Costs

USD 1.8 mil / year

 

 

You project that the pilot run has a 60% chance of being successful (i.e. outcome is positive). 

To finance the pilot run and the full-scale project, Johnny and his associates decide to use 50% debt and 50% equity. An investor who is Johnny’s high school buddy, Barry Lawson, agrees to enter into a special arrangement in which 5-year promissory notes with a face value of USD1000 per note will be sold to Barry at a price of USD694.11 per note. These notes do not make intermediate interest payments. (Note: Consider annual compounding for the promissory notes.)

You gather some market data to work out the equity beta for the project and it is determined to be 1.50. Further, the market return and T-bill rate are 11 % and 4%, respectively. Assume the T-bill rate is an appropriate proxy for the risk-free rate of return. Profits and losses from the project will be taxed at a rate of 34%. 

Assume the Capital Asset Pricing Model (CAPM) is valid.

Required 

a)     Determine the after-tax cost of debt.  (1 mark) 

b)     Determine the cost of equity. (1 mark) 

c)     Calculate the weighted average cost of capital for the project. (2 marks) 

d)     What is the present value of the cash flows at year 1 if outcome from the pilot run is positive and the team decides to launch the project in full scale? Ignore your answer in 

part c) and use 10% as the appropriate discount rate. [Hint: Consider cash flows from 

year 1 onwards]           

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