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Analyzing Information Pertaining to Two Ordinary Share investments

Introduction to Corporate Finance

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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:

EconomyProbabilityEstimated rate of return
Aussie TradersBlue Star LimitedASX 200
Recession30%-20%5%-4%
Average20%15%6%11%
Expansion35%30%8%17%
Boom15%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%. 

YEARRENOVATEREPLACE
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)


Answer

Question 1:


Economy
Probability (X)Estimated rate of return (Y)Expected Return (R)Variance (V)
Aussie Traders(X * Y)X * |Y-ΣR|2
Recession30%-20%-6%0.03675
Average20%15%3%0.00000
Expansion35%30%11%0.00788
Boom15%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:

EconomyProbability (X)Estimated rate of return (Y)Expected Return (R)Variance (V)
Blue Star Limited(X * Y)X * |Y-ΣR|2
Recession30%5%2%0.00012
Average20%6%1%0.00002
Expansion35%8%3%0.00004
Boom15%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:

EconomyProbability (X)Estimated rate of return (Y)Expected Return (R)Variance (V)
ASX 200(X * Y)X * |Y-ΣR|2
Recession30%-4%-1%0.00675
Average20%11%2%0.00000
Expansion35%17%6%0.00126
Boom15%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 Portfolio33.33%

% of Blue Star with respect to Portfolio66.67%




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 Portfolio66.67%

% of Blue Star with respect to Portfolio33.33%




Portfolio Beta = (β1 * A) + (β2 * B)

1.29



Expected Return (β=1.29)Ke = 5% + 1.29 ( 11% - 5%)
12.74%



Answer 7:

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:

Payback Period Renovation

= 90000/3000

= 3 years

  • Replace:

Payback period

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:

Net present value

Where:

= cost of investment

C= cash flow

r= discount rate

T= time


  • Renovation:


Renovation


  • Replace:



Replace


  • Recommendation:

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

  1. INTERNAL RATE OF RETURN(IRR):


Internal rate of return

Where:

ra= lower discount rate chosen

rb= higher discount rate chosen

NPVa= NPV at ra

NPVb= NPV at rb


  • Renovation:

NPVA =15%


Renovation NPVA =15%

NPVB =20%


Renovation NPVB =20%


  • Replace:

NPVA= 15%


Replace NPVA= 15%





NPVB= 20%

Replace 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. 


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