FINA2006 Principles of Finance

Jeff Smith, age 40, is the manager of a national, publicly funded soccer team in Australia. Smith has a one-year employment contract that has been renewed for several years. He is confident that he can maintain this job, or a similar managing position, until his planned retirement at age 55. Smith is divorced and the father of two teenage children. He wants to find a dedicated trust to provide for his children’s need until they reach age 25. He will need AUD 25,000 within the next few months to find the trust.

Smith’s tax rate is 30%. Other than a small cash reserves, he holds all of his investment assets in a tax-exempt account with a current value of AUD 900,000. Contributions to this account are made after tax. Withdrawals are tax-free, without penalty. Smith saves AUD 25,000 of his after-tax income every year, and plan to continue doing so until retirement. His next contribution is due in one year. As part of his normal expenses, Smith annually provides approximately AUD 30,000 of support to local youth sporting leagues.

When Smith retires in 15 year, he plans to purchase a 25-year annuity that pays AUD 100,000 after tax annually. He will need AUD 1,600,000 at retirement to fund the annuity. Smith expects the annual payout to be sufficient to meet all his needs on an inflation-adjusted basis. He does not plan to leave any estate at his death.

Calculate the required annual return that would enable Smith to purchase the retirement annuity at age 55. Assume all cash flows occur at the end of each period. 

Case study

Smith is considering investing in stocks of Company P. Table 1 summarises data related to the stocks of Company P.

Table 1: Data related to the stocks of Company P

Should Smith invest in the stocks of Company P if Smith requires a 10 return per annum

Case study

ABC Ltd. would like to set up a new expansion plant. Currently, ABC has an option to buy an existing building at a cost of AUD 30,000. Necessary equipment for the plant will cost AUD 20,000, including installation costs. The economic life of the equipment and building are 5 and 20 years respectively. The project would also require an initial investment of AUD 10,000 in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment.

The estimated economic life of the project is four years. At the end of that time, the building is expected to have a market value of AUD 25,000 and a book value of AUD 24,000, whereas the equipment is expected to have a market value of AUD 6,000 and a book value of 4,000.

Annual sales will be AUD 80,000. The production department has estimated that variable manufacturing costs will total 60% of sales and that fixed overhead costs, excluding depreciation, will be AUD 10,000 a year. Depreciation expense will be determined for the year using straight-line depreciation method.

ABC’s tax rate is 40%; its cost of capital is 12%; and, for capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.

Compute the initial investment outlay, operating cash flow over the project’s life, and the terminal-year cash flows for ABC’s expansion project. Then determine whether ABC Ltd should accept the project. What project evaluation technique do you think is most appropriate to evaluate this project 

Case study 

Using the monthly prices of stocks of CBA and monthly prices of the market index (Australian All Ordinaries) in Table 2 (Page 3), perform the following calculations.

1. Monthly returns from stocks of CBA
2. Yearly returns from stocks of CBA
3. Average yearly returns over the five years from stocks of CBA
4. Monthly returns from Australian All Ordinaries
5. Yearly returns from Australian All Ordinaries
6. Average yearly returns over the five years from Australian All Ordinaries
7. Total risk associated to investment in CBA stocks (perform one calculation using 60 monthly returns)
8. Total risk associated to investment in Australian All Ordinaries (perform one calculation using 60 monthly returns)
9. Systematic risk of stocks of CBA (perform one calculation using 60 monthly returns)
10. Unsystematic risk of stocks of CBA (perform one calculation using 60 monthly returns)