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# ECF5220 Principles of Finance

## QUESTION 1

Mega Ltd has a chain of tailoring and garment alteration stores around the city. They are now considering the establishment of a new branch in a new shopping centre in a developing suburb. The company has been offered a 5 year lease by the shopping centre. You have been provided with the following information:

i)              The new branch would require an initial investment of \$70,000 for machinery, depreciated at 20% per annum on a straight-line basis. After 5 years the machinery would have a salvage value of \$6,000.

ii)            A computer would be required to connect to the company’s central system. This will cost \$3,000 and be depreciated over 3 years on a straight-line basis. The computer will have no value at the end of 5 years.

iii)          Sales are projected to be \$250,000 per annum.

iv)          Recurring costs of the new branch would be:

Staffing \$80,000 per annum.

Rent (payable in advance) \$48,000 per annum. Insurance \$12,000 per annum.

Light and power \$15,000 per annum.

Inventories (fabric, thread, small tools etc.) \$10,000 per annum.

A proportion of head office costs amounting to \$10,000 per annum.

v)            Last year the company carried out market research which suggested that the new branch would be viable, this research cost \$20,000.

vi)          The company pays tax at 30% and its after tax cost of capital is 15% per annum.

vii)        The company’s bank has advised that it will charge 10% per annum for a five-year loan to fund the set-up of the new branch. Available cash is not enough to fund the project. The company will have to borrow the balance amounting to \$50,000.

Prepare the cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the project using the information given above. Briefly explain the items, if any, that are not included in the cash flow table. Calculate the payback period and the net present value (NPV) for the project. Should Mega Ltd go ahead with the new branch based on the NPV me

QUESTION 2

(A)    The following financial information relates to the operation of Pluto Ltd:

Pluto Ltd: Selected Balance Sheet data

 \$ Liabilities Accounts payable 250,000 8% Debentures, \$100 par value 800,000 Mortgage loan 500,000 Shareholders’ funds 5% Preference shares, \$20 par value 500,000 Ordinary shares, issued and paid up at \$5 2,000,000 Retained earnings 300,000

1.        Debentures which pay semi-annual coupon of 8% per annum are currently selling at \$100.50 each and mature in 5 years’ time.

2.        Current mortgage loan has eight years remaining until maturity and the interest charged monthly is 9% per annum. A new loan is estimated to cost 8.4% per annum on similar terms.

3.        The current market price of each preference and ordinary shares are \$21.00 and \$8.00, respectively.

4.        Pluto last paid a dividend of \$0.40 per share, and it is expected to grow at an annual rate of 3% in perpetuity.

5.        The company income tax rate is 30 cents in the dollar.

You are required to calculate the after-tax weighted average cost of capital (effective annual rate) for Pluto ltd

(B)        Explain the economic order quantity model and how it can be used to minimise company’s total costs associated with inventory.

QUESTION 3

(A)        Kevin invested \$20,000 in Share P and \$30,000 in Share Q. The expected returns and variances of returns on P and Q, and the covariance between their returns are given below.

 Share P Share Q Expected return 0.14 0.20 Variance 0.0225 0.0576 Covariance between the returns 0.03

i)          Find the expected return and standard deviation for Kevin’s portfolio.

[5 marks]

ii)        Assume that the risk-free rate of return is 6% and share Q has the same expected return and risk as the market portfolio. Calculate the beta for Share P and determine if Share P is correctly priced according to the capital asset pricing model.

[4 marks]

(B)        A rational risk-averse investor is faced with an opportunity set of five risky portfolios with expected returns and standard deviation as listed below. Plot the five risky portfolios in an expected return and standard deviation space. Indicate which portfolios are dominant with respect to their expected return and risk.

Portfolio

Expected Return

Standard Deviation

A

0.10

0.20

B

0.12

0.15

C

0.20

0.35

D

0.25

0.30

E

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