3 | P a g eClients Financial Questions: (25 marks) •Your client considered investing in either debt securities or equity securities and would like to know what are the main characteristics that distinguish the return on debt securities from the return and on equity securities? (12 marks)
•Why does the yield change through time but the coupon rate does not? (4 marks) •The total risk of an individual share comprises both systematic and unsystematic risk. Explain both of these risk components and describe how each is affected by increasing the number of shares in a portfolio. (5 marks)
•Your client is unsure why are investors focused on market risk only when applying the Capital Asset Pricing Model (CAPM) to price risky securities? (4 marks)
4 | P a g eClients Investments: (40 marks) 1.Douwe Ltd. is a logistics company with the following balance sheet: Long-term debt $ Bonds: Par $100, annual coupon 7% p.a., 3 years to maturity 3,000,000Equity Preference shares 1,000,000Ordinary shares 6,000,000Total 10,000,000Notes: The company’s bank has advised that the interest rate on any newdebt finance provided for the projects would be 8.5% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 500,000 preference shares on issue, which pay a dividend of $0.17 per year. The preference shares currently sell for $2.50. The company’s existing 6,000,000 ordinary shares currently sell for $0.95 each and management has disclosed that it expects to pay a dividend of 5 cents per share at the end of the next year. Historically, dividends have increased at an annual rate of 7% p.a. and are expected to continue to do so in the future. The company’s tax rate is 30%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to Douwe would be 12% p.a. Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing).
a)What are the assumptions underlying the use of a dividend growth model for the estimation of a company’s cost of equity?
b)Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital structure.
c)Calculate the after-tax costs of capital for each source of finance.
d)Determine the after-tax weighted average cost of capital for the company.)
Under what conditions can the firm’s weighted average cost of capital be used for assessing new projects?
f)Provide recommendation to your client. (14 marks)
2.Your client is evaluating two mutually exclusive projects, X and Y. The cost of capital is 12%, and expected cash flows of the two projects are as follows: Year 0 1 2 3 4 5 Project X -$1,200 250 290 460 470 510 Project Y -$1,200 320 500 450 270 260 What is the payback period of the better project? (8 marks) 3.A firm that your client would like to invest is only accepts projects providing an IRR more than 15%. The company is evaluating an eight-year project that requires $74,515 in initial investment and provides $15,000 in annual net cash inflows.
(a) What is the IRR of the project? Is it acceptable?
(b) Assuming the annual net cash inflows continue to be $15,000, how many additional years would the flows continue in order to make the project acceptable (that is, to have an IRR of 15%)?
(c) With the given project life (8 years) and initial investment, what is the minimum annual net cash inflows in order to make the project acceptable? (8 marks)
4.Your client is considering investing in one of the two Treasury bonds which have a face value of $100,000 and pay coupons at the rate of 10% semi-annually. Bond P has four years to maturity and bond Q has eight years to maturity. Your client would like to know:
(a) If the current interest rate is 7.5% p.a., what are the prices of the two bonds? (b)If the interest rate rises to 12% p.a., what are the prices of the two bonds? (c)What are the observations can be made based on these results?