FIN2101 BUSINESS FINANCE II
MODULE 3 - APPLICATION OF CAPM
QUESTION 1
The three divisions of Bonza Ltd are engaged in leisure wear,graphics,and household paint,The company has identified listed companies in each of these lines of business,On the basis of analysing the performance of the shares of those companies in relation to the market index,Bonza has estimated that the systematic risk of each of its three divisions is as follows:
Division
Beta
Leisure wear
1.16
Graphics
1.64
Paint
0.70
The expected return on the market index is 13% in the foreseeable future,and the risk-free rate is currently 7%,The divisions are evaluating a number of independent projects which have the following expected returns:
Project
Division
Return
1
Graphics
18%
2
Paint
12%
3
Paint
10%
4
Leisure wear
26%
5
Leisure wear
13%
6
Graphics
21%
7
Paint
14%
8
Graphics
16%
Which projects should be accepted and which rejected?
QUESTION 2
The risk-free rate is presently 5% and the expected return on the market portfolio is 10%,The expected returns (based on market prices) for four (4) companies' ordinary shares are listed below,together with their expected betas.
Company
Expected Return (ks)
Beta
Stillman Zinc Corp
12.0%
1.3
Union Paint Co
9.5%
0.8
National Auto Co
10.5%
1.1
Parker Electronics Ltd
13.0%
1.7
On the basis of these expectations,which shares are overvalued? Which are undervalued?
QUESTION 3
Sutton Safes Ltd has a debt-to-equity ratio (at market values) of 0.75 (3:4),Its present cost of debt funds is 10% before tax,and its marginal tax rate is 30%,Sutton Safes is considering entry into the automated-teller-machine business,a field that involves electronics and is considerably different from its own,so that the company is looking for a proxy company which might provide it with a relevant discount rate,Peerless Machines Ltd,a listed company,produces only automated-teller equipment,Peerless Machines has a debt-to-equity ratio of 0.25 (1:4),a beta of 1.15,and an effective tax rate of 30%.
a) If Sutton Safes wishes to enter the automated-teller-machine business,what systematic risk (beta) is involved if it intends to employ the same amount of leverage in the new venture as it presently employs?
If the risk-free rate is expected to be 6% and the market risk premium 6%,what return should the company require for the project if it adopts a capital asset pricing model approach?
QUESTION 4
Matthews-Lynch Ltd,a manufacturer of kicking machines,is currently contemplating manufacturing try scoring machines,an area in which it has no experience,It proposes to finance this project,which will cost $100 000 initially,by borrowing $40 000,the balance coming from equity sources,The project is expected to last at least twenty (20) years.
The present yield to maturity of 20-year Government bonds for investments of $20 000 and over is 8%,whilst the current debt finance rate for projects of this nature is 12%,Matthews-Lynch’s financial advisor has indicated that the market risk premium is approximately 6%.
An investigation of all current try scoring machine manufacturers reveals the following information:
Company
Debt/Equity Ratio
Beta
Bennett-Ikin Ltd
1:3 (0.33)
1.20
Stuart-Fittler Ltd
1:4 (0.25)
1.50
Anderson-Kimmorley Ltd
1:4 (0.25)
1.60
The corporate tax rate is 30 percent.
Former Bennett-Ikin Ltd manager,Wally Langer,estimates that this investment would return annual after-tax net cash inflows of $15 000 over the 20-year life of the project but he has a habit of disagreeing with himself from one day to the next.
Using the CAPM approach,advise Matthews-Lynch Ltd as to the acceptability of the project on the basis of the above information,Comment on the validity of the conclusions you have reached.
QUESTION 5
The stockbroking firm Insider Trading Pty Ltd employs you as a trainee market analyst in its research department,After a short time you note that:
the risk-free rate is 8%;
the expected rate of return on the market portfolio is 14%;
the market risk premium is 6%;
the expected returns (based on market prices) and betas for two (2) companies’ ordinary shares are as follows:
Company
Expected Returns (ks)
Beta
A
5.3%
1.40
B
24.2%
1.15
Required:
a) Calculate the required returns on Share A and Share B,given their levels of systematic risk.
b) Plot both the expected and required returns for each share on a Security Market Line.
c) Identify which of the shares is undervalued or overvalued,and briefly explain your answer.
d) Describe the adjustment process required to return Shares A and B to the SML.
29.07.03
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 3 - APPLICATION OF CAPM
QUESTION 1
First calculate the required return for each division and then compare the expected return for each project to the required return for the appropriate division,A project should be accepted if its expected return is greater than the division’s required return.
Accept projects 1,2,4,6 and 7.
QUESTION 2
A share is OVERVALUED or OVERPRICED when its required rate of return kj is greater than its expected rate of return based on market price ks,Conversely,a share is UNDERVALUED or UNDERPRICED when its required return is less than the expected return based on market price.
QUESTION 3
(a) Step 1 - Degear Levered Proxy Beta
Step 2 - Regear Unlevered Proxy Beta
(b)
QUESTION 4
Step 1 - Calculate Industry Average Data
Step 2 - Degear Levered Proxy Beta
Step 3 - Regear Unlevered Proxy Beta
Note,The project’s debt-to-equity ratio is $40 000:$60 000 or 2:3 (0.67).
QUESTION 4 (Continued)
Step 4 - Calculate the Cost of Equity Capital
Step 5 - Calculate the Cost of Debt
Step 6 - Calculate the Cost of Capital
Step 7 - Evaluate the Project
Conclusion: The project is unacceptable as it has a negative NPV,However,given the project’s long life and the uncertainty about the cash inflows,we might do further research before making a final decision to reject the project.
QUESTION 5
a)
c) Share A is OVERVALUED - it is giving a return (at its current market price) of only 5.3% when a share of its level of systematic risk should be giving a return of 16.4%.
Share B is UNDERVALUED - it is giving a return (at its current market price) of 24.2% compared with a required return (given its systematic risk) of 14.9%.
d) No one will buy Share A as it is overpriced,Eventually its market price will drop so as to provide the investor with a return that is commensurate with its level of risk.
On the other hand,demand for Share B will be high as it is giving an excess return,This demand will push the share price up,With the market price increasing,the return will drop to 14.9% so that the share will again plot on the SML.
05.08.02
MODULE 3 - APPLICATION OF CAPM
QUESTION 1
The three divisions of Bonza Ltd are engaged in leisure wear,graphics,and household paint,The company has identified listed companies in each of these lines of business,On the basis of analysing the performance of the shares of those companies in relation to the market index,Bonza has estimated that the systematic risk of each of its three divisions is as follows:
Division
Beta
Leisure wear
1.16
Graphics
1.64
Paint
0.70
The expected return on the market index is 13% in the foreseeable future,and the risk-free rate is currently 7%,The divisions are evaluating a number of independent projects which have the following expected returns:
Project
Division
Return
1
Graphics
18%
2
Paint
12%
3
Paint
10%
4
Leisure wear
26%
5
Leisure wear
13%
6
Graphics
21%
7
Paint
14%
8
Graphics
16%
Which projects should be accepted and which rejected?
QUESTION 2
The risk-free rate is presently 5% and the expected return on the market portfolio is 10%,The expected returns (based on market prices) for four (4) companies' ordinary shares are listed below,together with their expected betas.
Company
Expected Return (ks)
Beta
Stillman Zinc Corp
12.0%
1.3
Union Paint Co
9.5%
0.8
National Auto Co
10.5%
1.1
Parker Electronics Ltd
13.0%
1.7
On the basis of these expectations,which shares are overvalued? Which are undervalued?
QUESTION 3
Sutton Safes Ltd has a debt-to-equity ratio (at market values) of 0.75 (3:4),Its present cost of debt funds is 10% before tax,and its marginal tax rate is 30%,Sutton Safes is considering entry into the automated-teller-machine business,a field that involves electronics and is considerably different from its own,so that the company is looking for a proxy company which might provide it with a relevant discount rate,Peerless Machines Ltd,a listed company,produces only automated-teller equipment,Peerless Machines has a debt-to-equity ratio of 0.25 (1:4),a beta of 1.15,and an effective tax rate of 30%.
a) If Sutton Safes wishes to enter the automated-teller-machine business,what systematic risk (beta) is involved if it intends to employ the same amount of leverage in the new venture as it presently employs?
If the risk-free rate is expected to be 6% and the market risk premium 6%,what return should the company require for the project if it adopts a capital asset pricing model approach?
QUESTION 4
Matthews-Lynch Ltd,a manufacturer of kicking machines,is currently contemplating manufacturing try scoring machines,an area in which it has no experience,It proposes to finance this project,which will cost $100 000 initially,by borrowing $40 000,the balance coming from equity sources,The project is expected to last at least twenty (20) years.
The present yield to maturity of 20-year Government bonds for investments of $20 000 and over is 8%,whilst the current debt finance rate for projects of this nature is 12%,Matthews-Lynch’s financial advisor has indicated that the market risk premium is approximately 6%.
An investigation of all current try scoring machine manufacturers reveals the following information:
Company
Debt/Equity Ratio
Beta
Bennett-Ikin Ltd
1:3 (0.33)
1.20
Stuart-Fittler Ltd
1:4 (0.25)
1.50
Anderson-Kimmorley Ltd
1:4 (0.25)
1.60
The corporate tax rate is 30 percent.
Former Bennett-Ikin Ltd manager,Wally Langer,estimates that this investment would return annual after-tax net cash inflows of $15 000 over the 20-year life of the project but he has a habit of disagreeing with himself from one day to the next.
Using the CAPM approach,advise Matthews-Lynch Ltd as to the acceptability of the project on the basis of the above information,Comment on the validity of the conclusions you have reached.
QUESTION 5
The stockbroking firm Insider Trading Pty Ltd employs you as a trainee market analyst in its research department,After a short time you note that:
the risk-free rate is 8%;
the expected rate of return on the market portfolio is 14%;
the market risk premium is 6%;
the expected returns (based on market prices) and betas for two (2) companies’ ordinary shares are as follows:
Company
Expected Returns (ks)
Beta
A
5.3%
1.40
B
24.2%
1.15
Required:
a) Calculate the required returns on Share A and Share B,given their levels of systematic risk.
b) Plot both the expected and required returns for each share on a Security Market Line.
c) Identify which of the shares is undervalued or overvalued,and briefly explain your answer.
d) Describe the adjustment process required to return Shares A and B to the SML.
29.07.03
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 3 - APPLICATION OF CAPM
QUESTION 1
First calculate the required return for each division and then compare the expected return for each project to the required return for the appropriate division,A project should be accepted if its expected return is greater than the division’s required return.
Accept projects 1,2,4,6 and 7.
QUESTION 2
A share is OVERVALUED or OVERPRICED when its required rate of return kj is greater than its expected rate of return based on market price ks,Conversely,a share is UNDERVALUED or UNDERPRICED when its required return is less than the expected return based on market price.
QUESTION 3
(a) Step 1 - Degear Levered Proxy Beta
Step 2 - Regear Unlevered Proxy Beta
(b)
QUESTION 4
Step 1 - Calculate Industry Average Data
Step 2 - Degear Levered Proxy Beta
Step 3 - Regear Unlevered Proxy Beta
Note,The project’s debt-to-equity ratio is $40 000:$60 000 or 2:3 (0.67).
QUESTION 4 (Continued)
Step 4 - Calculate the Cost of Equity Capital
Step 5 - Calculate the Cost of Debt
Step 6 - Calculate the Cost of Capital
Step 7 - Evaluate the Project
Conclusion: The project is unacceptable as it has a negative NPV,However,given the project’s long life and the uncertainty about the cash inflows,we might do further research before making a final decision to reject the project.
QUESTION 5
a)
c) Share A is OVERVALUED - it is giving a return (at its current market price) of only 5.3% when a share of its level of systematic risk should be giving a return of 16.4%.
Share B is UNDERVALUED - it is giving a return (at its current market price) of 24.2% compared with a required return (given its systematic risk) of 14.9%.
d) No one will buy Share A as it is overpriced,Eventually its market price will drop so as to provide the investor with a return that is commensurate with its level of risk.
On the other hand,demand for Share B will be high as it is giving an excess return,This demand will push the share price up,With the market price increasing,the return will drop to 14.9% so that the share will again plot on the SML.
05.08.02
