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This Assignment consists of four questions. All questions must be answered.
Please answer all questions in the spaces provided after each question.
Two extra pages are included at the end of the Assignment. If more pages are required, please copy (or extend) page 12.
QUESTION `1. [8 + (8 + 6) = 22 Marks.]
This is a three period certainty model problem.
Assume that John Brown has a sole income from a trust which will pay him $40,000 now, $30,000 in one year and $60,000 in two years’ time. John wishes to consume $32,000 now and $42,000 in one year. How much can he consume in two y...

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#### Question Preview:

This Assignment consists of four questions. All questions must be answered.
Please answer all questions in the spaces provided after each question.
Two extra pages are included at the end of the Assignment. If more pages are required, please copy (or extend) page 12.
QUESTION `1. [8 + (8 + 6) = 22 Marks.]
This is a three period certainty model problem.
Assume that John Brown has a sole income from a trust which will pay him $40,000 now, $30,000 in one year and $60,000 in two years’ time. John wishes to consume $32,000 now and $42,000 in one year. How much can he consume in two years’ time if the capital market offers an interest rate of 5% per year?
This question relates to the Capital Asset Pricing Model (CAPM)
Best Flowers Ltd owns shares in four different companies, as follows:
Company Name Expected Return (%) Beta
Shamrock Ltd 10.4% 0.4
Camellia Ltd 12.9% 0.7
Rose Ltd 13.8% 1.1
Daffodil Ltd 17.6% 1.6
The risk free rate of interest is currently 8% and the market risk premium is 6%.
Based on the CAPM, which of the above shares are undervalued, overvalued or correctly valued? Show all calculations.
Using the above information, draw a Security Market Line graph, and plot all securities on the chart.
QUESTION 2. [(4 + 6) + (4 + 6) = 20 Marks]
This question relates to the time value of money and deferred perpetuities.
Orange Olives Ltd returns nothing to the owners in the first 4 years. In the following 3 years, the returns are $80,000, $130,000 and $180,000 respectively.
After that, the return is $250,000 a year in perpetuity. The required return is 6 per cent per annum. All returns are received at the end of each year.
What is the present value of the constant income flows at the beginning of the eighth year?
What is the present value now of the whole income stream?
This question relates to loan repayments and loan terms.
Two years ago, Lisa Brown borrowed $700,000 to recondition her travel cruiser. The loan from APC Bank required equal monthly repayments over 12 years, and carried.an interest rate of 8.4% per annum, compounded monthly.
Today, after making the last monthly payment for the second year, the bank tells Lisa that the interest rate will be increased immediately to 10.2%, compounded monthly, in line with market rates. It also tells her that, with the rise in rates, she has two alternatives. She can increase her monthly repayment (so as to pay off the loan by the originally agreed date), or she can keep paying the same monthly repayment as now, but this will mean that she must extend the term of the loan.
You are required to calculate:
The new monthly repayment if Lisa accepts the first alternative.
The extra period added to the term of the loan if Lisa adopts the second alternative.
QUESTION 3. [(6 + 6) + (8 + 4) = 24 marks]
This question relates to risk and return.
Billy Black has invested one-quarter of his funds in Share A and three-quarters of his funds in Share B. The expected return on Share A is 14% and on Share B is 20%. The standard deviation of share A is 17% and on Share B is 24%. The correlation between returns is 0.5.
What are the expected return and the standard deviation on Billy’s portfolio?
Is Billy better off by maintaining his existing two-share portfolio, or should he have invested all his funds in one security, and if so, which one? Give reasons for your recommendat
This question relates to the valuation of bonds.
Sarah Green, a retired school teacher, has two 8 per cent per annum $100,000 Australian Government bonds that mature on 15 April 2019 and 15 April 2023 respectively. At the date of the last half-yearly interest payment, viz., 15 October, 2016, both bonds were selling at par.
Since then, interest yields on bonds have risen by 2% per annum, compounded half-yearly. Sarah now intends to sell the bonds and put a deposit on a country property.
Calculate the price she will receive from each bond if she sells on 15 January, 2017 at the new yield. [Hint: There are 92 days from 16 October, 2016 to 15 January, 2016 inclusive, and 182 days from 16 October, 2016 to 15 April, 2017.]
Explain the relative price movements in the two bonds, as evidenced in your answer to i) above.
QUESTION 4. [30 + 4 = 34 marks].
This question relates to capital budgeting.
Capital Constructions Ltd is considering the purchase of equipment costing $400,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 5 years.
The new equipment will permit the company to reduce its to reduce its labour costs by $170,000 a year for 5 years, and the equipment may be depreciated for tax purposes by the straight-line method to zero over the 5 years. The company thinks that it can sell the equipment at the end of 5 years for $30,000.
The equipment will need to be stored in a building, currently being rented out for $20,000 a year under a lease agreement with 5 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Capital Constructions Ltd can cancel the lease by paying the tenant (now) compensation equal to one year’s rental payment plus 10%, but this amount is not deductible for income tax purposes.
This is not the first time that the company has considered this purchase. Twelve months ago, the company engaged Clever Consultants, at a fee of $23,000 paid in advance, to conduct a feasibility study on savings strategies and the company made the above recommendations. At the time, the company did not proceed with the recommended strategy, but is now reconsidering the proposal.
The company further estimates that, starting in 2 years’ time, it will have to spend $10,000 every 2 years overhauling the equipment. It will also require additions to current assets of $27,000 at the beginning of the project, which will be fully recoverable at the end of the fifth year.
Capital Constructions Ltd’s cost of capital is 14%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
REQUIRED:
Calculate the net present value, that is, the net benefit or net loss in present value terms of the proposed purchase and the resultant incremental cash flows.
Should the company purchase the equipment? State clearly why or why not.

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