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BUACC3701 Financial Management

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Question 1. (6 marks) Bent Ltd has determined in the following tables its preferred market risk – return function, certainty equivalents and details of two mutually exclusive projects it is considering. Risk Discount Index Rate 0 0.07 Risk Free Rate 0.20 0.08 0.40 0.09 0.60 0.10 0.80 0.11 1.00 0.12 1.20 0.13 1.40 0.14 1.60 0.15 1.80 0.16 2.00 0.17 Project A Project B Initial Investment 22000 29000 Useful Life 5 5 Annual Cash Flow 6800 10000 Risk Index 0.20 1.40 Certainty Equivalents Project A Project B Year 0 1 1 1 0.95 0.9 2 0.9 0....

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Question 1. (6 marks) Bent Ltd has determined in the following tables its preferred market risk – return function, certainty equivalents and details of two mutually exclusive projects it is considering. Risk Discount Index Rate 0 0.07 Risk Free Rate 0.20 0.08 0.40 0.09 0.60 0.10 0.80 0.11 1.00 0.12 1.20 0.13 1.40 0.14 1.60 0.15 1.80 0.16 2.00 0.17 Project A Project B Initial Investment 22000 29000 Useful Life 5 5 Annual Cash Flow 6800 10000 Risk Index 0.20 1.40 Certainty Equivalents Project A Project B Year 0 1 1 1 0.95 0.9 2 0.9 0.8 3 0.9 0.7 4 0.85 0.7 Greater than 4 0.8 0.6 a)Evaluate the projects using Certainty Equivalents b)Evaluate the projects using Risk Adjusted Discount Rates c)Discuss your findings in a and b above and explain why the two approaches are alternative techniques for considering risk in capital budgeting Question 2. (10 marks) The homo economicus view of man’s behaviour as applied to the bulk of finance theory portrays decision makers and being both self-interested and rational. Neoclassical economics makes some fundamental assumptions about people: 1. People have rational preferences across possible outcomes or states of nature. 2. People maximize utility and firms maximize profits. 3. People make independent decisions based on all relevant information. In light of the following hypothetical experiments, discuss the above Experiment 1: Ten people are in Room X (givers) with a further ten people in Room Y (takers). Each giver in Room X will be paired with a taker in Room Y although they will not know the identity of the other. Givers have been given $20 and can transfer any part of their $20 to a taker in Room Y. Takers can either choose to keep the amount sent, in which case the amount proposed is final or else reject the amount sent, in which case both individuals receive nothing. That is, you can send any dollar amount from $0 to $20 and the taker can accept this offer, or reject it, in which case you both receive nothing. For example, If the taker accepts and you send $10, you keep $20 - $10. You are a giver. How much do you give? Experiment 2: Ten people are in Room X (givers) with a further ten people in Room Y (takers). Each giver in Room X will be paired with a receiver in Room Y although they will not know the identity of the other. Givers in Room X have been given $20 and can transfer any part of their $20 to a taker in Room Y. The taker cannot reject the amount sent. You are a giver. How much do you send? For example, If you send $10, you keep $20 - $10. Experiment 3: Ten people are in Room X (givers) with a further ten people in Room Y (returnee). Each giver in Room X will be paired with a returnee in Room Y although they will not know the identity of the other. Givers have been given $20 and can transfer any portion of their $20 to a returnee in Room Y. Every dollar sent by a giver is tripled on receipt by the returnee. Returnees have the ability to send money back to the givers which would range between $0 and three times the amount received. You are a giver. How much do you send? Question 3. (10 marks) Busted Ltd has determined the following estimated levels of EBIT along with the probability of these occurring. It has on issue 80,000 shares which are currently selling at $40 each and presently has no debt. It is considering scenarios of introducing 10%, 20%, 30%, 40%, 50% and 60% levels debt. The total capital structure would remain the same with the debt replacing share capital. The company tax rate is 30%. Busted has determined the following probabilities Probability of EBIT 100 ($000s) 10% 200 ($000s) 15% 300 ($000s) 35% 400 ($000s) 15% 500 ($000s) 20% 600 ($000s) 5% The cost of debt for each ratio (interest rate) is as follows Debt Debt Ratio % 0% 0.000 10% 0.080 20% 0.095 30% 0.100 40% 0.115 50% 0.140 60% 0.170 a)Compute the EPS for each expected level of EBIT. Which structure maximises EPS? b)Compute the standard deviation and coefficient of variation of EPS for all the levels. I.e. 0%, 10%, 20%, 30%, 40%, 50% and 60%. What conclusions can you draw from these measures of risk? The firm also considers that the required rate of return on ordinary shares is related to its coefficient of variation on earnings per share. c)For each capital structure, what is the value of an ordinary share? Use the following earnings valuation model. Po = EPS/rs d)Which capital structure maximises shareholder wealth? e)Compare the capital structure selected in a above with that in d and discuss the implications of your findings. Question 4. (4 marks) Discuss the law of one price (lop) and what it suggests concerning arbitrage. Give reasons why it may not hold true.

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In this assignment, we evaluate projects based on “Certainty Equivalents” and “Risk Adjusted Discount Rates”. The findings under both capital budgeting processes have been explained. Furthermore, reasons have been provided for use of these alternative techniques in capital budgeting along with their respective process. The assignment provides solution to 3 experiments based on neoclassical economics and some fundamental assumptions.

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