ANSWER ALL QUESTIONS
- Diamond Ltd develops and manufactures equipment used in the mining industry. Although it is committed to maximising the wealth of its shareholders, the company has incurred heavy losses over recent years, which has been made worse since the outbreak of COVID-19. A new chief executive has now been appointed to revive the flagging fortunes of the company. As part of the revival process, a review has been ordered of all projects involving new equipment that was either still being developed or was already developed and about to be launched.
One such project began in 2019 to design a new specialised lift, the HL2000, which is to be used in deep mining shafts and has incurred costs of £4 million, to date, in developing and testing. The project had experienced numerous problems and the HL2000 has taken longer than expected to develop but it is now ready to market. The HL2000 is expected to generate sales over a four-year period, after which it will be replaced with an improved version.
The manager of Project HL2000 has produced the following calculations to aid the review process:
|Year 1||Year 2||Year 3||Year 4|
|Salary and wages||(12.7)||(14.4)||(6.6)||(2.5)|
|Materials and components||(2.3)||(3.5)||(1.5)||(0.6)|
|Interest charges on loan||(1.5)||(1.5)||(1.5)||(1.5)|
The manager of Project HL2000 is dismayed by the above results and believes that the new chief executive will call an immediate halt to the proposed launch when the results are presented to him. Before making the presentation, however, the project manager has asked you to check the figures that he has produced.
When going through the figures, you find the following:
(i) The materials and components are already in stock and were purchased specifically for producing the new lift. The materials and components are highly specialised and cannot be used for any other project. They have no ready market value and, if the HL2000’s is not manufactured, the materials and components will have to be disposed of immediately at a cost to the company of £0.2 million.
(ii) The overheads reflect a ‘fair share’ of the total overheads incurred by the company. However, the overheads that relate specifically to the project account for only 25% of the amount shown in each period.
(iii) The depreciation charge relates to existing plant and equipment which will be used for the manufacture of the HL2000. Although this has already been purchased, if the project does not go ahead it could be sold today for £6.0 million. If the project goes ahead, the plant and equipment will be sold for £2.0 million at the end of the project’s life.
(iv) Working capital of £2.5 million will be required immediately and will be released at the end of the four-year period of the life of the new HL2000 lifts.
(v) The development costs relate to the costs incurred during the period up to today. It is the policy of the company to write off development costs in equal annual instalments over the period in which revenues are generated.
(vi) Interest charges arise from a loan that has already been taken out specifically to finance the development and manufacture of the new lifts.
You can assume the calculations provided by the manager of Project HL2000 contain no arithmetic errors.
The company has a capital structure of 75% equity and 25% debt. The company’s cost of equity is 12% and the cost of debt is 8%.
- Calculate the Weighted Average Cost of Capital (WACC) for Diamond plc
- Using the WACC calculated in part (a) and the additional information provided by the project manager, calculate the net present value of the new HL2000 lift project and briefly comment on the viability of the project.
- Briefly explain to the project manager the reasons for any adjustments that you have made to the figures provided for the HL2000 project when calculating the NPV and discuss why the net present value method is appropriate when assessing the financial viability of the new lift.
- Having recently graduated with a master’s degree in finance and investments, you have been employed by a large investment company, Safe Hands Investments. During your first week at the company Mr Peters, the Head of International Portfolios at Safe Hands Investments, approaches you to conduct some preliminary calculations for a current international portfolio that is being considered.
Mr Peters explains that the company is considering investing in a combination of four national stock market indices. The expected return and standard deviation of each of these is shown below:
Expected Return Standard Deviation
USA 0.08 0.30
Germany 0.10 0.20
Indonesia 0.12 0.35
Latvia 0.13 0.40
You have been told that the correlations between pairs of market indices are as follows:
USA / Germany 0.9;
USA / Indonesia 0.3;
USA / Latvia 0.5;
Germany / Indonesia 0.7;
Germany / Latvia 0.8;
Indonesia / Latvia -1.0
- Calculate the expected return and standard deviation if 50% of the portfolio is invested in USA, and the rest is divided equally between Germany and Indonesia.
- What portfolio weights should the investor use to eliminate standard deviation completely by investing in Indonesia and Latvia?
A crucial decision for these investors is the optimal number of stocks to own…The methods used to determine the optimal number of stocks vary but, in general…a portfolio of 8 to 20 stocks is typically considered sufficient to achieve the full benefits of diversification
(Domian et al., 2003)
- Discuss the extent to which empirical evidence supports the above contention regarding the number of assets required for effective portfolio risk diversification.
- You are asked to carry out a valuation of Newkirk plc (Newkirk), which is located in Edinburgh and listed on the London Stock Exchange. An extract from Newkirk year-end Statement of Financial Position for 2020 is summarised as follows.
Extract from Newkirk Statement of Financial Position (31 December 2020)
Newkirk relevant trading information is listed as follows.
|Year-end||Earnings per share (pence)||Dividend per share (pence)|
The beta for Newkirk is 1.2 and the risk-free rate of return on UK Treasury bills is 6%. A latest study shows an annual equity risk premium over the yield on UK government bonds of 5% for the past 100 years. The impressive average annual growth in Newkirk’s earnings and dividends over the last few years is likely to persist.
You have also obtained an independent valuation of Newkirk’s fixed assets at £360 million. However, it is believed that Newkirk has overstated the value of inventory by £30 million and one-quarter of its receivables are likely to be uncollectable. Newkirk has 1,000 million shares in issue. In addition, there have been no new issues of shares in the past eight years.
(a) Calculate the value of Newkirk using the net asset value method.
(b) Calculate Newkirk’s share price (per share) using the dividend valuation model. (Assume the dividend of 10p has just been paid and the next dividend will due in one year)
(c) What is the prospective price to earnings ratio (P/E ratio) given the share price in (b)
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(d) The balance sheet entry ‘long-term payables’ consists entirely of the value of a debenture issue, which has a pre-tax cost of debt of 9%. The market value of these debentures is £50 million, and Newkirk has a tax rate of 30%.
Using the share valuation calculated in part (b), calculate the WACC of Newkirk.
(e) “Firm valuation is mainly based on the principle of continuous future going concern… Some firms are clearly exposed to possible financial distress, and the choice of firm valuation methods can be problematic… For firms in financial difficulty, the net asset valuation approach is particularly useful… The net asset valuation approach yields more merits than drawbacks.”
With reference to academic literature, critically discuss the above statement.
- Larissa Warren is the owner of East Coast Yachts Ltd, a yacht manufacturing company based in the United Kingdom. During the past few years the company’s sales have risen sharply with increased demand for yachts coming from both domestic and overseas markets. Despite the increase in demand, East Coast Yachts has begun to have difficulties in obtaining some of the electronic devices needed in the production of their yachts from the usual local suppliers.
In order to address this problem, Larissa has been in discussions with a yacht dealer in Malaysia about importing 60,000 of the electronic devices needed, which will meet the current demand for their yachts.
The Malaysian seller is in a strong bargaining position and has priced the devices in Malaysian dollars at M$10 each. In addition, they have agreed to grant East Coast Yachts Ltd three months’ credit.
The Malaysian interest rate is 12% per year. East Coast Yachts Ltd has all its money tied up in its operations but could borrow in pounds sterling at 10% per year if necessary.
The exchange rates have been volatile in recent months. The spot rate is M$5.4165/£, and the three-month forward rate is M$5.425/£.
Larissa Warren is considering different strategies to reduce the currency transaction risks. She is particularly interested in two hedging strategies, including a forward market hedge and a money market hedge.
(a) Calculate the value payable in pounds sterling in three months’ time using a forward market hedge.
(b) If the assumed spot rates at the end of three months are M$4.00/£ and M$7.00/£ respectively. Explain whether the forward market hedging strategy works.
(c) Calculate the sterling value payable in three months’ time using a money market hedge.
(d) Explain which hedge is preferable.
(e) If all other rates remained the same, calculate the forward rate needed for Interest Rate Parity to hold.
(f) Besides the future hedge and money market hedges strategies, Larissa Warren is also considering other strategies, such as internal techniques to reduce foreign exchange transaction risks. Outline the situations when these internal techniques can be used to reduce foreign exchange exposure, and critically discuss their merits and drawbacks.
(End of Paper)
1 Expected return on a 2 security portfolio is given by
RP = E(Rp)= XA(ERA) + XB(ERB)
Where Xa is the proportion of share 1 in the portfolio and Xb is the proportion of share 2 in the portfolio. ER is the expected return of the individual securities.
2 Standard deviation on a 2 security portfolio is given by
sP = Ö XA2(σA2) + XB2(σB2) + 2 CorrA,B (σA)(σB) (XA)(XB)
Where X1 is the proportion of share 1 in the portfolio and X2 is the proportion of share 2 in the portfolio. σ is the standard deviation and CorrA,B represents the correlation between securities 1 and 2
3 The proportion X of share 1 in the minimum risk portfolio is given by
Where cov(RA,RB) represents the Covariance between securities 1 and 2
cov(RA, RB) = RABsAsB
4 The current value of a share is given by
P0 = D1/(ke – g)
5 The growth rate in above is derived from
6 Weighted Average cost of capital is given by
WACC = Ke() + Kd()
Where Ke is the cost of equity capital
“ Kd is the cost of debt
Ve is the value of equity capital
Vd is the value of debt capital.
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