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Part A: 20 Marks

Brandon Ltd is considering the following expansion.

Details are as follows:

 Stock Stock A Sales Working Year Market Share Units Year Capital t Index Price Outlays 1993 2005 5.00 510000 0 \$ 2,100 1994 2201 5.50 550000 1 \$ 2,600 1995 2410 5.75 540000 2 \$ 3,200 1996 2520 5.90 560000 3 \$ 3,700 1997 2602 6.00 565000 4 \$ 4,100 1998 2835 6.10 590000 5 \$ 4,500 1999 2650 6.00 600000 6 \$ 4,000 2000 2502 5.90 610000 7 \$ 3,500 2001 2854 6.50 615559 8 \$ – 2002 3210 7.00 669000 2003 3420 7.25 700000

Project Life: 8 years

Capital outlays are as follows:

Beginning of project: \$1,500,000

Upgrade at end of third year: \$700,000

Scrap / Salvage value: \$25,000

The firm applies the reducing balance method of depreciation to its projects. For tax purposes the Tax Commissioner allows the use of straight line depreciation.

The investment analyst has decided to forecast the sales (units) by using time-trend projections. These are to be adjusted from year four onwards to account for the increased sales resulting from the upgrade, which is estimated as 0.5 million units per year.

Product price is expected to be 55 cents per unit for the first five years, and 80 cents thereafter. Production cost is estimated to be 12 cents per unit. Other operating costs (which do not include depreciation) are \$55,000 per year for the first five years and \$60,000 per year for the rest of the project life.

Company tax rate is 34%

Government bond yield is 5.2%

The managers believe that the degree of risk of the proposed project is basically the same as that of the existing business risk. The analyst would like to use a risk-adjusted discount rate calculated by employing the CAPM.

Required:

Calculate the Accounting Rate of Return (ARR), Payback Period, NPV and IRR. ARR has many variants and you are required to define your method used for your calculation.

Part B: 10 Marks

Consider a portfolio comprising of a \$3 million investment in Ariel Ltd and a \$5 million investment in in Snowy Ltd. Assume that the standard deviations of the returns for the shares are 0.4 and 0.25 respectively. Assume also that the correlation between the returns on the shares in these companies is 0.7. Assume a 4% chance of abnormally bad market conditions and that returns follow a normal probability distribution.

Required:

a.

Explain the Value at Risk (VaR) approach to examining risk

b.

Calculate the value at risk of each individual investment and then of the portfolio.

c.

Calculate the value of risk for the portfolio if the correlation between investments increases to .85

d.

Calculate the value of risk for the portfolio if the correlation between investments increases to 1

e.

Calculate the value of risk for the portfolio if the correlation between investments decreases to .55

f.

Assessment Criteria:

Student work will generally be assessed in terms of the following criteria:

1. Effectiveness of communication – ie readability, legibility, grammar, spelling, neatness, completeness and presentation will be a minimum threshold requirement for all written work submitted for assessment. Work that is illegible or incomprehensible and does not meet the minimum requirement will be awarded a fail grade.

2. Accuracy – This will be the primary criterion for assessing the computational and procedural tasks.

3. Demonstrated understanding – This will be evidenced by the student’s ability to be dialectical in the discussion of contentious issues. Few, if any, accounting concepts are scientific facts and stereotype answers will demonstrate poor understanding on the part of the student.

4. Evidence of research – This will be evidenced by the references made to the statutes, accounting standards, books, journal articles and inclusion of a bibliography.

Note:

1. All written work must conform with the University of Ballarat General Guide for the Presentation of Academic Work.

2. For all written work students must ensure that they submit their own original work. Any act of plagiarism will be severely penalised.