Assessment Task 2
(2005) Semester 1 , 2020
BACC5936 Financial Management
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PART A (10 Marks)
1. Obrien Group wishes to accumulate funds to provide a retirement annuity for its Director of Research, Peter Alexander; Mr. Alexander by contract will retire at the end of exactly 12 years. On retirement, he is entitled to receive an annual end-of-year payment of $42,000 for exactly 20 years. If he dies prior to the end of the 20-year period, the annual payments will pass to his heirs. During the 12-year 'accumulation period', Obrien wishes to fund the annuity by making equal annual end-of-year deposits into an account earning 9 percent interest. Once the 20-year 'distribution period' begins, Obrien plans to move the accumulated monies into an account earning a guaranteed 12 percent per year. At the end of the distribution period the account balance will equal zero. Note the first deposit will be made at the end of year 1 and the first distribution payment will be received at the end of year 13.
Required:
a) What is the time value of money? Explain using the above scenario and draw a timeline depicting all the Cash flows associated with Obrien's view of the retirement annuity.
(1 Mark)
b) How large a sum must Obrien accumulate by the end of year 12 to provide the 20-year, $42,000 annuity?
(1 Mark)
c) How large must Obrien's equal annual end-of-year deposits into the account be over the 12-year accumulation period to fund fully Mr. Alexander’s retirement annuity.
(1 Mark)
d) How much should Obrien have to deposit annually during the accumulation period if it could earn 10 per cent rather than 9 per cent during the accumulation period?
(2 Marks)
e) How much would Obrien have to deposit annually during the accumulation period if Mr. Alexander’s retirement annuity was a perpetuity and all other terms were the same as initially described?
(2 Marks)
2. A newly divorced father of two, looking to improve his image wants to purchase a Mercedes-Benz in order to impress his young and foxy girlfriend. The car costs $17,999 and the car yard is willing to offer financing. The terms of the deal include a $2000 deposit (which the client has) with the remainder of the balance being repaid in equal monthly installments over the next three years. The car dealer charges 1.25 percent interest rate per month on the balance of the outstanding loan.
Required: Calculate the size of each monthly payment and then prepare a loan amortization schedule to show that as time passes the amount paid in interest by your client is reduced.
(3 Marks)
PART B (7 Marks)
3. The risky portfolio A consists of 1000 shares of BIT PLC and 4000 shares of DIMO PLC. Assume that BIT PLC has a share price of $6, an expected return of 18%, and a standard deviation of 22%. DIMO PLC has a share price of $4, an expected return of 14%, and a standard deviation of 20%. The correlation between the two is 0.6, and the risk-free rate of interest is 8%.
Required
a) Graph the Capital Allocation Line derived from the risk-free asset and portfolio A. (Label all axes and points carefully).
(1 Marks)
b) What fraction of your portfolio must you invest in A to have a portfolio standard deviation of 12%?
(2 Marks)
4. BLUECHIP PLC just paid a dividend of $2.00 per share. The managing director just announced that it is planned to increase dividends at a rate of 6% indefinitely. An appropriate discount rate for this company is 16% per annum.
a) What is the firm’s expected dividend stream over the next 3 years? (1 Mark)
b) What is the firm’s current stock price? (1 Mark)
c) What is the firm’s expected value in one year? (1 Mark)
d) What is the expected dividend yield, capital gains yield and total return during the first year? (1 Mark)
PART C (8 Marks)
5. Your friend Nigel is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Nigel's rich uncle has left him $20 million in his will. Having been a management student, Nigel partied while you studied. In fact, he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Nigel watched an interview with the Guru Jack ma. The Guru claims material wealth lies beneath the ground in Melbourne. It is clear from the tone of the interview, the title of the documentary was -An interview with a crackpot,- that the interviewer and the -experts- on the show think the Guru is insane. However, Nigel believes in the Guru because his management training taught him to believe in gurus (Peter Drucker, for example). Nigel decides to use his new-found fortune to prove the Guru correct, making himself one of the richest people in Australia in the process! Nigel knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million. In addition, the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment. You and Nigel meet with the Guru and after several hours of meditation the Guru provides you with estimated annual after-tax cash-flows. These cash-flows are in millions and are provided to you below in table 2-1. Nigel thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%.
a) Should Nigel invest his fortune based on the crackpot's ideas?
(3 Marks)
b) Would your decision change if you used a discount rate of 18% or 10% ? Support the answer with the NPV and IRR.
(5 Marks)
Table 2-1
Projected Cashflow Projected Cashflow
Year 1 $1,500,000 Year 11 $2,500,000
Year 2 $3,278,000 Year 12 $2,500,000
Year 3 $5,000,000 Year 13 $2,500,000
Year 4 $6,450,000 Year 14 $2,500,000
Year 5 $2,500,000 Year 15 $2,500,000
Year 6 $2,500,000 Year 16 $2,500,000
Year 7 $2,500,000 Year 17 $2,500,000
Year 8 $2,500,000 Year 18 $2,500,000
Year 9 $2,500,000 Year 19 $2,500,000
Year 10 $2,500,000 Year 20 $2,500,000
Projected Cash Flows
note
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