Bond P is a bond with a face value of $1,000,000, coupon rate of 8% pa and makes half-yearly payments. It has a YTM of 7% pa and five years to maturity. a) What is the current yield (%) pa for bond P?

b) If the interest rate remains unchanged, what is the expected capital gains yield (%) pa over the next year for bond P? (8%)

Type your answer here:

Price at t =0 is

Coupon per period = 80000

n = 5

r =

A_{n, r}=  7%

Price at t = 1 year is

n = 5 years

r =

A_{n, r}= 0.07

Current yield = ?

Capital Gains Yield =?

Bond Price = Coupon x An, r + Face Value (1 + r) n

C = 1,000,000× 8%

=80000

Pv = 80000 × 0.07 + 1000000 (1+ 0.07) 5

Pv = 5600 + 1000000 × 1.402

Pv = 5600+1402000

Pv = 1407600

Current yield = yearly coupon/ price at f

= 80000 / 1.402

= 57061

Capital gain yield = Pt+1 - Pt Pt

1.402 – 57061/ 57061

= 0.9999 %

Question 3 (10%)

Gingin Music Company is considering the sale of a new sound board used in recording studios. The new board would sell for $30,000 and the company expects to sell 2,000 per year. Gingin currently sells 1,800 of its existing models per year. If the new model is introduced, sales of the existing model will fall to 1,500 units per year. The old board retails for $25,000. Variable costs are 50% of new sales, depreciation on the equipment to produce the new board will be $1,000,000 per year, and fixed costs are $2,000,000 per year. If the tax rate is 30%, what is the annual OCF for the project?

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Question 4 (10%)

Share J has a beta of 1.30 and an expected return of 14%, while Share K has a beta of 0.9 and an expected return of 11%. You want a portfolio with the same risk as the market. How much will you invest in each share? What is the expected return (%) of your portfolio?

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Weight J = 1/1.30 = 76.90%

Weight K =100%-76.90% = 23.1%

Return J = 14%

Return K =11%

Question 5 (10%)

Dampier Diamond Mines Ltd has a target capital structure of 70% ordinary shares, 5% preference shares and 25% debt. Its cost of equity is 12%, the cost of preference shares is 4.5% and the cost of debt is 5%. The relevant tax rate is 30%.

a) What is the firm’s WACC (%) under a classical tax system? (5%)

b) The company CEO has approached you about Dampier Diamond's capital structure. He wants to know why the company does not use more preference-share financing, since it costs less than debt. What would you tell the CEO? (5%)

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D/V = D/D+E = 25%/25%+70% = 26.32

E/V = E/D+E = 70%/70%+25% = 73.68

P/V = P/D+P = 5%/25%+5% = 16.67

r_d = 5%

r_e =12%

r_p = 4.5 %

What do you tell the CEO?

The cost of ordinary shares is higher than preferred shares due to which the overall cost of capital is increasing. The corporation can decrease its WACC by changing its current capital structure. One option is to use more preference shares because they have lower cost. The second way is to increase the amount of debt and decrease the amount of equity. As debt has lower cost the corporation should consider to finance its assets more from debt than equity. The optimum capital structure is to finance 40% from debt and 60% from equity.

PART 2 (50%)

Question 6      (10%)

Some of the following statements are incorrect.  Identify three of them and explain briefly why you think they are incorrect.

a)         Risk free rate means the risk is the same as a Treasury Note of any country.

b)         In a semi-strong efficient capital market, investors cannot make any abnormal return.

c)         A weak form efficient capital market means abnormal profit cannot be made from past information.

d)         Equity risk premium is the excess return of a market portfolio over the risk free rate.

e)         A “Bell-shaped curve” is always normally distributed.

Type your answer here:

The statement number one, three and four are incorrect. In reality there is no such thing as risk free. The Treasury note in any country might have some amount of risk associated with them. People can lose money from treasury notes if they did not invested carefully. The equity risk premium is actually the excess return that stock markets provides on the risk free rate. The statement mention here is referring to the market risk premium not equity risk premium. In weak form efficient market past information does not predict future prices but it does not mean that abnormal profit cannot be made.

Question 7      (10%)

Trevino and Nelson wrote about three distinct theories regarding ethical decision, explain clearly what is meant by one of the theories.

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The nelson and Trevino wrote about distinct theories regarding ethical decision making. These include focus on integrity, focus on consequences and focus on obligations and duties. According to the authors focusing on consequences necessary for making ethical decision. if the businesses are going to focus on consequences than they will not take such decision which have negative consequences on the business to people associated with them. Focusing on consequences will allow the organization to understand whether their actions are serving the society or not. From the economic point of view the focus on consequences will allow the organization to understand whether the benefit is more than the cost or not.

Question 8      (10%)

In your Group Assignment, you assessed some financial ratios.  Explain the meaning of TWO of the ratios that you assessed.

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Debt to equity ratio is a financial leverage ratio that provides information regarding how much cash the corporation has to pay its longer term loans. The debt to equity ratio provides information about how much debt the corporation has taken in a specific period. If the debt to equity ratio is higher than it means that the organization has taken too much debt and the corporation is highly levered. The ROE ratio provides information about the profitability of the corporation. The higher the ROE ratio the higher will be the profitability of the organization. The corporation who generate profit provide higher returns on the equity and have high ROE ratio.

Question 9      (10%)

Some of the following statements are incorrect.  Identify three of them and explain briefly why you think they are incorrect.

a)         When financial leverage of a company is decreased, the debt/equity of the company decreases and the value of the company increases.

b)         In 1958, MM proposed that a shareholder can create value by taking on more debt.

c)         Under the Dividend Imputation Tax system, only some shareholders must pay additional tax to the tax office.

d)         Under the 1963 MM classical tax system, the value of an unlevered firm is equal to the value of the levered firm minus the present value of the debt.

e)         Financial distress cost is present ONLY when a company raises debt beyond the optimal level.

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The financial distress cost not only include the cost of debt. The financial distress cost also includes bankruptcy cost which include legal fees etc. under dividend imputation system all the shareholders have to pay additional tax not some of the shareholders. Therefore this statement is also not correct. The value of unlevered firm cannot be equal to levered firm because when the firms get unlevered the capital reduces (for instance shares) the value of the firm than also reduces as a result.

Question 10    (10%)

Some of the following statements are incorrect.  Identify three of them and explain briefly why you think they are incorrect.

a)         Preference share dividend must be paid to the preference shareholders every year.

b)         Clientele effect argues that dividend policy is relevant as investors can choose companies with a dividend policy that will meet their requirements in the long run.

c)         A company will decrease dividends immediately when there is a crisis like Covid-19.

d)         A share price usually decreases with the announcement of a drop in forecasted profit.

e)         Most companies do not want to maintain consistency with the historical dividend policy.

Type your answer here:

A share price might not always decreases when the profit of the corporations decreases. If the corporation is huge and earned profit over the last several years than decline in profit might not have much effect on the price of shares. The preference share dividend is given to the preference shareholders only when the corporation has generated profit. If the corporation has not generated profit than the preference shareholders might not get dividend.

FORMULAE

S = Future Value

P or A = Present Value

n = number of cashflows or periods

r = interest rate per period

t = Days to maturity

A_{n, r} = PV Annuity Factor

S_{n, r} = FV Annuity Factor

1. S = P (1+r)ⁿ

2. P =

3.   )

4. S =  

5. A_{n, r} = )

6. S_{n, r}  =

7. S = P (1 + rt)

8. Bond Price = Coupon x A_{n, r} +  

9. NPV = - cost + PV (Future Cashflow)

10.

11.

12. OCF = (Rev – Expenditure – Depreciation ) (1 - t_c) + Depreciation

13. 

14. 

15.

END OF THE EXAMINATION