MAF603 – JUNE 2016

MAF 603 SUGGESTED SOLUTIONS

SOLUTION 1

i. Expected Return (A) = 0. 3 (15%) + 0.5 (20%) + 0.2 (22%) √

= 18.9%

Expected Return (B) = 0. 3 (12%) + 0.5 (15%) + 0.2 (18%) √

= 14.7%

Expected Return (C) = 0.3 (17%) + 0.5 (20%) + 0.2 (24%) √

= 19.9%

Variance (A) = 0.3 (15%-18.9)2√ + 0.5 (20%-18.9)2√ + 0.2 (22%-18.9)2√

= 4.563% + 0.605% + 1.922%
= 7.09

Std Dev= √7.09

= 2.66% √

Variance (B) = 0.3 (12%-14.7)2√ + 0.5 (15%-14.7)2√ + 0.2 (18%-14.7)2√

= 2.187% + 0.045% + 2.178%
= 4.41

Std Dev= √4.41

= 2.1% √

Variance (C) = 0.3 (17%-19.9)2√ + 0.5 (20%-19.9)2 √+ 0.2 (24%-19.9)2√

= 2.523% + 0.005% + 3.362%
= 5.89

Std Dev= √5.89

= 2.43%
(14√ x 1/2 = 7 marks)
ii.
Security Expected return Std deviation
(%) (%)
A 18.9 2.66
B 14.7 2.1
C 19.9 2.43

Choose stock B and C. √√

Most of the investors are risk averse, thus they will choose the lower risk for investment
purposes. √√

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Alternative answer:
(If only students assume and state the investors are “risk takers”)

Choose stock C and A. √√

Assuming the investors are risk taker, therefore the two with the higher returns will be
chosen, stock C and A √√
(4√ x 1/2 = 2 marks)

iii.

Expected return (portfolio) = 0.5√ (18.9%) + 0.5√ (19.9%)

= 19.4%
(2√ x ½ = 1 mark)

iv.
Required return (portfolio) = RF + βP (RM – RF)
= 0.05√ + 1.303√ (0.1 √– 0.05)
= 11.5%√
CAPM Required Expected Return Evaluation Investment Decision
Return
11.5%√ 19.4%√ under-priced Buy √

The portfolio is not correctly priced. It is underpriced √. The expected return of the
portfolio (19.4%) is higher√ than the required return of the portfolio (11.5%). √

(10√ x 1/2 = 5 marks)

v. Required return (portfolio) = RF + βP (RM – RF)

= 0.05 + 0.9√ (0.1 – 0.05) √
= 9.5%
CAPM Required Expected Return Evaluation Investment Decision
Return
9.5% 19.4% under-priced Buy √

The portfolio is not correctly priced. It is underpriced √. The expected return of the
portfolio (19.4%) is higher√ than the required return of the portfolio (9.5%).
(4√ x ½ = 2 marks)

vi. Beta is the responsiveness of a stock’s return with the return on the market. √
The magnitude of beta describes the impact of systematic risk on a stock’s
return. √√
(3 marks)
(Total: 20 marks)

Question 2

A. Rationality- It is assumed that all investors are rational and when new information is
released in the market, all investors will adjust their estimates of stock prices in a rational
way. When the information of the crisis was known panic selling of stocks took place. It

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can be said that panic selling may not be representative of rational investors, although
there is the element of lack of confidence and certainty of the capital markets. √√√

Independent Deviations from Rationality- With many questions about the global financial
crisis going unanswered, many investors do not think clearly. If these individuals
dominate the market, stock prices will fall beyond what market efficiency will predict.
Most investors will tend to be irrationally pessimistic. There may however be some who
may still be irrationally optimistic. Prices may fall in a manner not consistent with market
efficiency as the irrationally pessimistic may outnumber the irrationally optimistic making
countervailing irrationalities not possible. When investors are in the throes of extreme
pessimism, can efficiency be assumed? √√√

Arbitrage- Are there sufficient rational professionals who estimate stock prices rationally
and objectively with detailed analysis, to dominate the markets and counteract the
actions of the irrational amateurs who act on their emotions and thus may cause stocks
to become under-priced due to their panic selling. The arbitrage of professionals may not
be able to dominate the actions of amateurs to make markets efficient in such a crisis.
√√√ √
(10√ x 1/2 = 5 marks)

B. i. Technical analysts would find their analysis based on past information not useful
because they would not be able to predict the future direction of a stock’s price to their
advantage. √
ii. Insider Traders can make abnormal profits based on private information as it is
not publicly available. √
(1√ x 2.5 = 5 marks)

C. i. RM4867 = 1749.61SGD√√√
RM2.78176

RM1 = 0.35948SGD√√√
RM2.78176
(6√ x 1/2 = 3 marks)

ii. The AUD is worth more than the NZD as more RM can be exchanged for AUD
than NZD. √
(1 mark)

iii. a. i. The USD is worth more as 1 AUD will buy 0.73509USD. √√

(2 marks)
ii. The USD is selling at a discount because it is less expensive in
the forward market than in the spot market (AUD1.36037 versus
AUD1.34535). √√
(2 marks)
iii. The USD is expected to appreciate in value relative to the AUD
because it takes more AUD to buy 1USD in the future than it does
today. √
(1 mark)
b. Interest rates in the US are higher than they are in Australia. √
(1 mark)
(Total: 20 marks)

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Question 3

i. Present B/S = 0.25

Annual interest = RM1.5 million

6% x Total debt = RM1.5 million
Total debt = RM1.5 million / 0.06
= RM25 million

B = 0.25
S = 1.00
V= 1.25

VL = 1.25√/0.25√ x RM25 million√√ = RM125 million

(4√ x1/2 = 2 marks)

ii. According to MM Proposition 1 (without tax), VL=Vu

Vu = EBIT/Ro
RM125 million √= RM12.5 million √/Ro
Ro = 10%√

Rs = Ro + B/S x (Ro – Rb)

= 10%√OF + 0.25 √ (10% - 6%)√
= 11%
(6√ x1/2 = 3 marks)

iii. New B/S = 0.5

Rs = Ro + B/S (Ro – Rb)

= 10%√OF + 0.5√ (10% - 6%)√
= 12 %√

Rwacc = Ro = 10% ( in a world without tax ) √

(5√ x1 = 5 marks)

iv. As the firm increases the B/S ratio, the risk of equity increases and therefore the
required return Rs on equity will increase. √ Rwacc is unaffected by leverage and thus,
Rwacc will remain the same. √ Thus, the stock price will increase on the announcement
of the proposed stock buy back. √

(3√ x1= 3 marks)

v. In a world with tax, Rs = Ro + B/S (Ro – Rb) (1 – Tc)

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Rs will decrease or Rs increases at a lower rate because the firm pays less tax since
interest is tax deductible. √
Rwacc will decrease due to the higher tax shield from an increase in debt. Cost of debt
financing becomes cheaper and overall cost of capital is reduced. √
(2√ x1= 2 marks)

vi. In a world without taxes, according to MM Proposition 1 the level of debt does not affect
the value of the firm. √ The value of the firm will remain the same irrespective of the level
of debt. √
With taxes, the increase in the level of debt √ will increase the value of the firm √ due to
the increase in the tax shield. √
(5√ x 1 = 5 marks)
(Total: 20 marks)

Question 4

a. APV = NPV (Base Case) – Net Processing Fee + NPV (Loan)

NPV (Base Case)

-Initial Outlay + PV of depreciation tax shield + PV of after tax net revenue

√ √ √ √ √ √ √ √
= -RM30 million + 0.25(RM30m - RM3m/5 years)(A 4%, 5years) + RM7.6m (1-0.25)( (A 12%, 5
years) + 3m(P 12%, year5) √√

= -RM30 million + 0.25(RM5.4m)(4.4518) + 0.75(RM7.6m)(3.6048) + 3m(0.5674)

= -RM30 million + RM6,009,930 + RM20,547,360 + 1,702,200

= -RM1,740,510√

Net Processing Fee

Total Loan = RM25 million

1% processing fee = RM25 million X 1% = RM250,000

Annual deduction = RM250,000/5 years = RM50,000

Annual tax shield = RM50,000 X 0.25 = RM12,500

Net Processing Fee = -Processing fee + PV of annual tax shield

√ √√√ √
= -RM250,000 + (RM12,500)(A 4% ,5 years)
= -RM250,000 + (RM12,500)(4.4518)
= - RM250,000 + RM55,647.50

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= -RM194,352.50√

NPV Loan

Gross Proceed – PV of after tax interest – PV of principal

√ √ √ √ √ √ √
= RM25million – 0.1 (25million) (1-0.25) (A 10%, 5 years) – RM25million(P 10%,5years)

= RM25million – 0.1(0.75)(25million)(3.7908) – RM25million (0.6209)

= RM25million – RM7,107,750 – RM15,522,500

= RM2,369,750

APV = -RM1,740,510 – RM194,352.50 + RM2,369,750

= RM434,887.50√

Decision: Accept the project because the APV is positive. √

(26√ X 0.5 marks = 13 marks)

b. NPV (Govt Loan)

√ √ √ √ √ √ √
= 25m – 25m(0.08)(1-0.25)(A 10%, 8 years) – 25m(P 10%, 8years)

= 25m – 1.5m(5.3349) – 25m(0.4665)

= 25m – 8,002,350 – 11,662,500

= 5,335,150

√ √
APV = -RM1,740,510 + RM5,335,150

= RM3,594,640

Decision: Accept the project since the APV is positive and higher than borrowing using
the bank loan√.
(10√ X 0.5 = 5 marks)

c. Sensitivity analysis can determine how the financial break-even point changes when
some factors (such as fixed costs, variable costs or revenue) changes.

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(2 marks)
(Total = 20 marks)

Question 5
a. Net present value of the acquisition:
Synergy = (RM1.6 m √ + RM3.4m √) / 10% √
= RM50m √

Value of combined firm = (3m√x RM10√) + (4.5m√ x RM20√) + RM50 m √

=RM170 m √

Net Present Value = Value of Ikan (to Jala) – Cost

= (RM30m + RM50m√) – [ (2m√ / 6.5m√√) (RM170m√)]
= RM27.69m √
(16√ x ½ = 8 marks)

b. Jala should proceed√ with the proposal as it gives a positive NPV. √

(2 marks)
c. Net Present Value = Value of Ikan to Jala – Cost
= RM80m√√ – (RM10√ x 150% √ x 3m√ )
= RM35 million √
Jala Bhd. should choose the cash option √√. Because it gives a higher positive NPV √√.
(10√ x ½ = 5 marks)

d. One factor that the acquiring company should consider in deciding the type of
financing options for the acquisition.
i. Overvaluation
If the management thinks the shares of the target firm are overvalued and/or
expensive, they should choose the stock option to finance the acquisition as it
will be less costly than the cash option.
ii. Taxes
Cash options usually trigger taxes while stock options are usually tax-free
iii. Sharing gains from the merger
The target shareholders will not enjoy any downstream synergies using the cash
option. However if the merger is not a success, any losses incurred will not be

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shared. In a stock option any gain or loss will be shared between the
shareholders of both the acquiring and target firms based on their percentage
shareholding.
(Any 1 with explanation x 2 = 2 marks)

e. The corporate charter

Refers to the articles of incorporation and corporate by- laws that govern the firm.
The charter is amended to make the takeover more difficult, such as instead of
2/3 approval, management may require 80% approval (super-majority
amendment). √√√

Golden Parachute
Providing compensation to top level management of the target firm if a takeover
occurs as they will be replaced by a new management team. √√√
(6√ x 1/2 = 3 marks)
(Total: 20 marks)

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