Question 2 (15 marks, 5 marks each)
a. Sally has invented a new household device that would earn her $10,000 per annum for the next 10 years. Given a rate of interest of 8%, would Sally be willing to sell her invention today for $100,000?
b. An investment will pay $100 at the end of each of the next 3 years, $200 at the end of year 4,
$300 at the end of year 5 and $500 at the end of year 6. Given that other investments of equal risk earn 8% per annum, calculate the present value and future value of this investment.
c. An investment firm X pays 10% interest per annum, compounded on a quarterly basis. To remain competitive, the investment manager of another firm (firm Y) is willing to match the interest rate offered by firm X, but interest will be compounded on a monthly basis. What nominal rate of interest must firm Y offer to its clients?
Question 3 (30 marks)
Advanced Tech Ltd is proposing the construction of a new plant in Singapore. It has recently completed a $3,000,000, two-year feasibility study on its latest project. It estimated that 50,000 units of its new geothermal heat pump could be sold annually over the next ten years at a price of $30,000 each. Subcontractors would install the pump at a cost of $5,000 per installation. Fixed costs of $5 million per annum will be incurred. The initial outlay includes $100 million to build production facilities and $30 million in land. The $100 million facility will be depreciated using the prime cost method over the project’s life (fully depreciated at the end of the project). At the conclusion of the project the facilities (including the land) will be sold for an estimated value of $50 million.
The firm pays taxes at a 30% rate in the year of income. It uses a 12% discount rate on the new project. Using the NPV approach, determine whether the project should be undertaken (use the tax rate provided in your analysis).
WA Mining Ltd’s bonds will mature in four years with a total face value of $40 million, paying a half yearly coupon rate of 6% per annum. The yield on the bonds is 14% per annum. The market value for the company’s preference share is $6.5 per unit while the ordinary share is currently worth $2.0 per unit. The preference share pays a dividend of $1.0 per share. The beta coefficient for the ordinary share is 1.5 and retained earnings are expected to be more than sufficient to fund the ordinary equity component of any new investment. The market risk premium is estimated to be 12% per annum and the risk-free rate is 4% per annum. The company is subject to a 30% corporate tax rate. The balance sheet values for bond and equity are shown below:
WA Mining Ltd
preference shares (100,000 units) $3
Ordinary shares (10 million units) $15
a. Explain the three steps involved in the calculation of cost of capital for WA Mining. (5 marks)
b. Calculate WA Mining’s after-tax weighted average cost of capital. (20 marks)
c. WA Mining is considering raising more capital for a new project. Should the company use more equity or debt? In your answer, discuss the effect of using more equity or debt on WA Mining’s cost of capital.