# Analyzing Information Pertaining to Two Ordinary Share investments

Introduction to Corporate Finance

BAP53

On your first day as an intern at Tri-Star Management Pty Ltd, the CEO asks you to analyse the following information pertaining to two ordinary share investments, Aussie Traders and Blue Star Limited. You are told that a one-year Treasury note will have a rate of return of 5% over the next year. Also, information from an investment advisory service lists the current beta for Aussie Traders as 1.68 and for Blue Star 0.52. You are provided a series of questions to guide your analysis:

 Economy Probability Estimated rate of return Aussie Traders Blue Star Limited ASX 200 Recession 30% -20% 5% -4% Average 20% 15% 6% 11% Expansion 35% 30% 8% 17% Boom 15% 50% 10% 27%

1. Using the above data, calculate the expected return for Aussie Traders, Blue Star Limited and ASX 200 Index. (2 MARKS)
2. Calculate the standard deviations of the estimated rates of return for Aussie Traders, Blue Star Limited and ASX 200. (2 MARKS)
3. Which is a better measure of risk for the ordinary shares of Aussie Traders and Blue Star Limited – the standard deviation you calculated or the beta? Why? (1 MARK)
4. Based on the beta provided, what is the expected rate of return for Aussie Traders and Blue Star Limited for the next year? (1 MARK)
5. If you are to form a two-share portfolio by investing \$50,000 in Aussie Traders and \$100,000 in Blue Star, what is the portfolio beta and the expected rate of return? (1.5 MARKS)
6. If you are to form a two-share portfolio by investing \$100,000 in Blue Star and \$50,000 in Aussie Traders, what is the portfolio beta and the expected rate of return? (1.5 MARKS)
7. Which of these two-share portfolios do you prefer? Why? (1 MARK)

Now that you have chosen your portfolio, the management is considering two alternative investment proposals. The first proposal calls for a major renovation of the company’s manufacturing facility, while the second proposal involves replacing the obsolete pieces of equipment in the facility. The company will choose only one project and the company will use the WACC at 15%.

 YEAR RENOVATE REPLACE 0 -\$90,000 -\$240,000 1 \$30,000 \$200,000 2 \$30,000 \$80,000 3 \$30,000 \$20.000 4 \$30,000 \$20,000 5 \$30,000 \$20,000

1. Calculate the payback period of each project and, based on this criterion, indicate which project you would recommend for acceptance. (2 MARKS)
2. Calculate the Net Present Value of each project and, based on this criterion, indicate which project you would recommend for acceptance. (2 MARKS)
3. Calculate the Internal Rate of Return of each project and based on this criterion, indicate which project you would recommend for acceptance. (2 MARKS)
4. Calculate the Profitability Index of each project and based on this criterion, indicate which project you would recommend for acceptance. (2 MARKS)
5. Overall, you should find conflicting recommendations based on the various criteria. Why is this occurring? (2 MARKS)

Question 1:

 Economy Probability (X) Estimated rate of return (Y) Expected Return (R) Variance (V) Aussie Traders (X * Y) X * |Y-ΣR|2 Recession 30% -20% -6% 0.03675 Average 20% 15% 3% 0.00000 Expansion 35% 30% 11% 0.00788 Boom 15% 50% 8% 0.01838 SUM (Σ) 15% 0.06300 Standard Deviation (√V) 25.10% Expected Return (β=1.68) Ke = 5% + 1.68 ( 11% - 5%) 15.08%

Question 2:

 Economy Probability (X) Estimated rate of return (Y) Expected Return (R) Variance (V) Blue Star Limited (X * Y) X * |Y-ΣR|2 Recession 30% 5% 2% 0.00012 Average 20% 6% 1% 0.00002 Expansion 35% 8% 3% 0.00004 Boom 15% 10% 2% 0.00014 SUM (Σ) 7% 0.0003 Standard Deviation (√V) 1.73%

 Expected Return (β=0.52) Ke = 5% + 0.52 ( 11% - 5%) 8.12%

 Question 3:Beta is the better measure of risk for the Aussie Traders and Blue Stars Limited because Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market. However, Standard deviation measures the dispersion of data from its expected value.

Question 4:

 Economy Probability (X) Estimated rate of return (Y) Expected Return (R) Variance (V) ASX 200 (X * Y) X * |Y-ΣR|2 Recession 30% -4% -1% 0.00675 Average 20% 11% 2% 0.00000 Expansion 35% 17% 6% 0.00126 Boom 15% 27% 4% 0.00384 SUM (Σ) 11% 0.01185 Standard Deviation (√V) 10.89%

Question 5:

 Aussie Traders \$50,000 Blue Star \$100,000 Total Portfolio \$150,000 Aussie Beta (β1) 1.68 Blue Star Beta (β2) 0.52 Portfolio Beta ? % of Aussie Traders with respect to Portfolio 33.33% % of Blue Star with respect to Portfolio 66.67% Portfolio Beta = (β1 * A) + (β2 * B) 0.91 Expected Return (β=0.91) Ke = 5% + 0.91 ( 11% - 5%) 10.46%

Question 6:

 Aussie Traders \$100,000 Blue Star \$50,000 Total Portfolio \$150,000 Aussie Beta (β1) 1.68 Blue Star Beta (β2) 0.52 Portfolio Beta ? % of Aussie Traders with respect to Portfolio 66.67% % of Blue Star with respect to Portfolio 33.33% Portfolio Beta = (β1 * A) + (β2 * B) 1.29 Expected Return (β=1.29) Ke = 5% + 1.29 ( 11% - 5%) 12.74%

 We would prefer to form a two-share portfolio by investing \$100,000 in Blue Star and \$50,000 in Aussie Traders because it has the highest Porfolio return of the two provided and offers the highest possible expected return for a given level.

Question 2:

1. PAYBACK PERIOD:-
2. Renovation:

= 90000/3000

= 3 years

• Replace:

Payback period

= 1 + 40000/80000

= 1 + 0.5

= 1.5 years

• Recommendation:

The second proposal to replace the obsolete pieces is more suitable as it takes less time to recover the investment.

1. NET PRESENT VALUE:

Where:

= cost of investment

C= cash flow

r= discount rate

T= time

• Renovation:

• Replace:

• Recommendation:

To replace the obsolete pieces is more suitable as it generates higher npv.

1. INTERNAL RATE OF RETURN(IRR):

Where:

ra= lower discount rate chosen

rb= higher discount rate chosen

NPVa= NPV at ra

NPVb= NPV at rb

• Renovation:

NPVA =15%

NPVB =20%

• Replace:

NPVA= 15%

NPVB= 20%

• Recommendation

To replace the obsolete pieces would be recommended as the IRR is higher.

1. PROFITABILITY INDEX:

PI = (NPV + Initial Investment) / Initial Investment

• Renovation:
• NPV = 10547.38
• Initial Investment = 90000

PI = (NPV + Initial Investment) / Initial Investment

= (10547.38 + 90000) / 90000

=1.12

• Replace:
• NPV = 28904.78
• Initial Investment = 240000

PI = (NPV + Initial Investment) / Initial Investment

= (28904.78 + 240000) / 240000

=1.12

• Recommendation:

Profitability of both the proposals is same, so any of the proposals can be accepted.

1. OVERALL RECOMMENDATION:

The recommendations are conflicting as both the proposals have different initial cost and the difference in cash flow timings.