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Business Finance

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Business Finance

 Business Finance

Question 1

i)             E(Rp) = (0.2) (0.14) + (0.8) (0.2) = 0.188

 

Variance ( 2) = (0.2)2 (0.0225) + (0.8)2 (0.0576) + 2 (0.2) (0.8) (0.8) (0.15) (0.24)

=  0.0009 + 0.036864 + 0.009216

=  0.04698

 

Standard deviation ( ) = (0.04698)1/2 = 0.21675

 

ii)           The security market line (SML) reflects the required return on an asset i for each level of systematic risk (or the beta). The market beta is one and the slope of SML is the risk premium of the market portfolio.

 

The SML provides a benchmark for the evaluation of investment performance and “fairly priced” assets plot on the SML. If a stock is underpriced, it is above the SML and overpriced stocks plot below the SML.

 

iii)         Beta = 0.8(0.15)(0.24)/0.0576 = 0.5 E(RX) = 6% + 0.5 (20% - 6%) = 13.0%

 

Share X is underpriced so its share price is expected to rise.

iv)         If investors become more risk-averse, the SML originates from the risk-free rate of return will become steeper.

 

The new SML with steeper slope indicates a high risk premium for Share A, and hence Share X’s required rate of return will increase.

Question 2 – Miller Ltd

 

Mortgage loan:

 

PV = -$600,000           n = 10×12         PMT = $10,000

i = 1.322%

 

Effective annual rate = (1 + 0.01322)12 – 1 = 17.0698%

After-tax cost = 17.0698% (1  0.3) = 11.9489%

 

MV = $ 600,000

Debentures:

 

PMT = -10%×$500/2 i = 8%/2 n = 7×2 FV = -$500 PV = $552.8156

Effective annual rate = (1 + 0.08/2)2 – 1 = 8.16%

After-tax cost = 8.16% (1 – 0.3) = 5.712%

 

MV = $552.8156 × 1,600 = $884,505

 

Preference shares:

 

rp = (8% × 1,000)/998 = 8.016%

 

MV = $1,000 × 500 = $500,000

 

Ordinary shares: -

 

re = 1.40/16.5 + 0.04 = 12.4848%

 

MV = $16.50 × 200,000 = $3,300,000

 

Cost of Capital

Market value

 

Proportion

 

Cost

 

After-tax

 

Wt Cost

Mortgage loan

 

 

 

 

 

 

 

 

 

 

 

 

 

 

600,000

 

0.1135

17.070%

11.9489%

1.3562%

 

10% Debentures

884,505

0.1674

8.160%

5.7120%

0.9562%

 

8% preference shares

500,000

0.0946

8.016%

 

 

0.7583%

 

Ordinary shares

3,300,000

0.6245

12.485%

 

 

7.7968%

 

 

 

5,284,505

1.0000

 

 

 

 

10.8675%

                       

 

 

 

Question 3 – Hayden Ltd

 

 

 

 

 

 

 

 

 

 

 

Year

0

1

2

3

4



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