Page 1 of 9 ASSIGNMENT 1 ST SEMESTER : FINANCIAL MANAGEMENT 3 () CHAPTERS COVERED : CHAPTERS 1, 5, 8-10 STUDY UNITS : STUDY UNITS 1-3 DUE DATE : 3:00 p.m. 18 March 2014 TOTAL MARKS : 100 INSTRUCTIONS TO CANDIDATES FOR COMPLETING AND SUBMITTING ASSIGNMENTS The complete Instructions to Students for Completing and Submitting Assignments must be collected from any IMM GSM office, the relevant IMM GSM recognised Additional Tuition Centre or can be downloaded from the IMM GSM website. It is essential that the complete instructions be studied prior to commencing your assignment. The following points highlight only a few important notes. 1. You are required to submit ONE assignment per subject. 2. The assignment will contribute 20% towards the final examination mark, and the other 80% will be made up from the examination, however the examination papers will count out of 100%. 3. Although your assignment will contribute towards your final examination mark, you do not have to earn credits for admission to the examinations; you are automatically accepted on registering for the exam. 4. Number all the pages of your assignment (e.g. page 1 of 4) and write your name and surname, student number and subject at the top of each page. 5. The IMM GSM requires assignments to be presented on plain A4 paper. You must show all working calculations, including and where appropriate multiple-choice working calculations. 6. A separate assignment cover, which is provided by the IMM GSM, must be attached to the front cover of each assignment. 7. Retain a copy of each assignment before submitting, in case the original does not reach the IMM GSM. 8. The assignment due date refers to the day up to which assignments will be accepted for marking purposes. The deadline is 3:00 p.m. on 18 March 2014. Late assignments will be accepted, but 25 marks will be deducted from the maximum mark, if received after 3:00 p.m. on 18 March 2014 and up to 5:00 p.m. the following day after which no assignments will be accepted. 9. If you fail to follow these instructions carefully, the IMM Graduate School of Marketing cannot accept responsibility for the return of the assignment. It may even result in your assignment not being marked. Results will be available on the IMM GSM website: www.immgsm.ac.za, on Friday, 2 May 2014.
Page 2 of 9 SPECIFIC INSTRUCTIONS: Answer ALL the questions. The use of calculators is permitted. Show ALL calculations. Read all questions carefully to determine exactly what is required before attempting to answer. Number your answers clearly and set them out under appropriate headings and sub-headings. QUESTION 1 [30] For each of the questions below you are provided with alternatives, a-e. You are required to select the most appropriate correct answer by writing only the question number and the respective letter for the answer in your assignment. Each correct answer is awarded two (2) marks. E.g. 1.21 b 1.1 Which ONE of the following statements is correct? a. The only cost of a specific source of capital that has to be adjusted for tax is the cost of debt. b. The internal rate of return (IRR) is zero when the net present value (NPV) is zero. c. The smaller the difference between internal rate of return (IRR) and the weighted average cost of capital (WACC), the larger the resulting net present value (NPV). d. Shares represent lenders claims on the assets of a company. e. All the above statements are correct. 1.2 The key features/advantages of the payback method of project analysis include the: I. application of a discount rate to each separate cash flow. II. bias towards liquidity. III. ease of use. IV. arbitrary cut-off point. a. I and II only b. I and III only c. II and III only d. II and IV only e. II, III, and IV only 1.3 One purpose of identifying all of the incremental cash flows related to a proposed project is to: a. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm. b. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project, leaving relevant cash flows. c. make each project appear as profitable as possible for the organisation. d. include both the proposed and the current operations of an organisation in the analysis of the project. e. identify any and all changes in the cash flows of the organisation for the past year so they can be included in the analysis.
Page 3 of 9 1.4 The expected return on a share that is computed using economic probabilities is: a. guaranteed to equal the actual average return on the share for the next five years. b. guaranteed to be the minimal rate of return on the share over the next two years. c. guaranteed to equal the actual return for the immediate twelve month period. d. a mathematical expectation based on a weighted average and not an actual anticipated outcome. e. the actual return you should anticipate as long as the economic forecast remains constant. 1.5 Which of the following are capital budgeting decisions? I. Determining whether to sell bonds or issue shares II. Deciding which product markets to enter III. Deciding whether or not to purchase a new piece of equipment IV. Determining which, if any, new products should be produced a. I only b. III only c. II and IV only d. I, III, and IV only e. II, III, and IV only 1.6 The payback method is frequently used to analyse independent projects because: a. it considers the time value of money. b. all relevant cash flows are included in the analysis. c. the cost of the analysis is less than the potential loss from a faulty decision. d. it is the most desirable of all the available analytical methods from a financial perspective. e. it produces better decisions than those made using either NPV or IRR. 1.7 The internal rate of return (IRR): I. rule states that a project with an IRR that is less than the required rate should be accepted. II. is the rate generated solely by the cash flows of an investment. III. is the rate that causes the net present value of a project to exactly equal zero. IV. can effectively be used to analyse all investment scenarios. a. I and IV only b. II and III only c. I, II, and III only d. II, III, and IV only e. I, II, III, and IV
Page 4 of 9 1.8 Which one of the following is an example of an incremental cash flow? a. the annual salary of the company CEO which is a contractual obligation. b. the rent on a warehouse which is currently being utilised. c. the rent on some new machinery that is required for an upcoming project. d. the property taxes on the currently owned warehouse which has been sitting idle but is going to be utilised for a new project. e. the insurance on a company-owned building which will be utilised for a new project. 1.9 The market risk premium: a. varies over time as both the risk-free rate of return and the market rate of return vary. b. plus the risk-free rate of return equals the cost of capital for any organisation with a beta of zero. c. is equal to one percent for a risk-free asset. d. is equal to the risk free rate of return multiplied by the beta of an organisation. e. is modified by the standard deviation when computing the cost of equity. 1.10 When conducting a worst case scenario analysis, you should assume that: a. the sales quantity is at the upper end of your expectations. b. the highest sales price obtainable in the market-place can be charged. c. no competition exists in the market-place. d. your variable costs per unit are at the high end of the spectrum of possible prices. e. your fixed costs are constant and at the low end of your cost range. 1.11 An option based on an underlying asset, such as a building or land, is called a a. financial investment decision. b. liquid option. c. fixed asset option. d. real option. e. tangible investment decision. 1.12 The Liberty Co. is considering two projects. Project A consists of building a wholesale book outlet on lot #169 of the Englewood Retail Centre. Project B consists of building a sit-down restaurant on lot #169 of the Englewood Retail Centre. When trying to decide whether to build the book outlet or the restaurant, management should rely most heavily on the analysis results from the method of analysis. a. profitability index b. internal rate of return c. payback d. net present value e. accounting rate of return
Page 5 of 9 1.13 Simulation analysis is based on assigning a and analysing the results. a. narrow range of values to a single variable b. narrow range of values to multiple variables simultaneously c. wide range of values to a single variable d. wide range of values to multiple variables simultaneously e. single value to each of the variables 1.14 Which one of the following is a correct statement concerning risk premium? a. The greater the volatility of returns, the greater the risk premium. b. The lower the volatility of returns, the greater the risk premium. c. The lower the average rates of return, the greater the risk premium. d. The risk premium is not correlated to the average rate of return. e. The risk premium is not affected by the volatility of returns. 1.15 Individuals who continually monitor the financial markets seeking mispriced securities: a. tend to make substantial profits on a daily basis. b. tend to make the markets more efficient. c. are never able to find a security that is temporarily mispriced. d. are always quite successful using only well-known public information as their basis of evaluation. e. are always quite successful using only historical price information as their basis of evaluation. (2 marks per question x 15) (30) QUESTION 2 [10] 2.1 Explain the main features of Economic Value Added (EVA ) as it would be used to assess the performance of divisions. (3) 2.2 Briefly explain how the use of EVA to assess divisional performance might affect the behaviour of divisional senior executives. (3) EHO consulting division had the following report during the month of January: Divisional profit R200 000 Income Tax 28% Total investor-supplied operating capital R1 000 000 WACC 11% 2.3 Using the above information on EHO consulting, calculate the EVA and state whether the division should be rewarded for their performance, if any. (4)
Page 6 of 9 QUESTION 3 [40] PART A (This question consists of three parts) When assessing the overall risk of a company, financial managers should take cognisance of business risk and financial risk. 3.1 Define business risk and discuss the method by which it may be measured. (2) 3.2 Define financial risk and discuss the method by which it may be measured. (2) 3.3 Discuss the actions a financial manager may take to reduce the overall risk of the company and the effects this may have on shareholders. (6) PART B SB Ltd has excess cash available and is considering investing it in either one of the following shares (Share A or Share B). You have been approached by the directors to aid them in their decision making. State of the economy Probability of occurrence Share A (%) Share B (%) Recession 0.15-11.0 28.0 Bad 0.10 10.0 23.0 Moderate 0.30 18.0 15.0 Good 0.25 26.0 7.0 Upswing 0.20 33.0-3.0 3.4 Calculate the expected return for both shares using the format provided below as a guide. (Round all answers to four decimal places.) (9) Share A Share B Outcome Recession Bad Moderate Good Upswing Recession Bad Moderate Good Upswing Return Probability Weighted Expected Value Return r i P ri r i x P ri = r i x P ri = =
Page 7 of 9 3.5 Calculate the standard deviation for both shares using the format provided below. (Round all answers to four decimal places.) (11) Share A Share B Outcome ( ) ( ) Variance Recession Bad Moderate Good Upswing Recession Bad Moderate Good Upswing = = = = Standard Deviation 3.6 Advise SB Ltd on which share they should invest in by performing the relevant calculations and making appropriate recommendations. (4) PART C You would like to estimate the rate of return of two investments, Buy-me and Buy-you, that have similar risk profiles. The following market values were established for the investments: Buy-me Buy-you Current year R29 000 R63 000 Prior year R28 000 R63 000 Cash flows generated during the current year were: Buy-me Buy-you Cash flows generated R9 500 R14 805 You can assume that past returns will serve as reasonable estimates of future returns. 3.7 Calculate the expected rate of return on the Buy-me investment and the Buy-you investment using the most recent years data. (4) 3.8 In light of the investments having similar risk profiles, which one should you choose? Why? (2)
Page 8 of 9 QUESTION 4 [10] PART A (This question consists of two parts) Market Build has estimated the cash flows over a 6-year period for two projects, A and B, as follows: Project A Project B R R Initial Investment 50 000 18 000** Year Operating Cash Flows 1 10 000 6 000 2 12 000 5 000 3 16 000 7 000 4 22 000 7 000 5 20 000 9 000 6 25 000 10 000 **After-tax cash inflow expected from liquidation Assume project A is actually a replacement for project B and the R18 000 initial investment shown for project B is the after-tax cash inflow expected from liquidating it. 4.1 Calculate and present the relevant cash flows for this replacement decision. (4) 4.2 Discuss why, in the above replacement scenario, it is important to evaluate the decision based only on incremental or relevant cash flows. (2) PART B Marky-Tech Ltd has spent R3.5 million over the past decade developing a market data mining program. It is currently trying to decide whether to spend an additional R350 000 on the project. The firm expects that this final outlay will finish the project and will generate cash flows of R1 million per year over the next five years. A competitor has offered R4.5 million for the program as it currently stands. 4.3 Classify each of the amounts/outlays spoken of in the above scenario as a relevant or irrelevant cash flow with regard to the decision. Where necessary you are required to indicate if the amounts would be a sunk cost or opportunity cost. Remember to justify each classification. (4)
Page 9 of 9 QUESTION 5 [10] PART A (This question consists of two parts) The following information regarding project Investbig is provided below: Capital Investment (R1 250 000) Year 1 R175 000 Year 2 R175 000 Year 3 R175 000 Year 4 R200 000 Year 5 R250 000 Year 6 R300 000 Year 7 R350 000 5.1 Calculate the payback period for the project. (2) 5.2 Assuming you are NOT equipped with the target payback period, discuss whether the project should go ahead. (1) PART B A company is considering purchasing a new machine which will cost R25 000. The annual benefit of using the machine would be R17 000 which is set to remain constant over the useful life of the machine. The running costs of the new machine will be R3 000 in the first year and thereafter will be expected to rise in line with general inflation of 6%. The company s real cost of capital is 13.2% and the expected life of the machine is three years. 5.3 Calculate the NPV (Net Present Value) in light of the information provided above and conclude on whether the new machine should be purchased. (Hint: The real cost of capital would need to be adjusted for inflation.) (7) ASSIGNMENT TOTAL: 100