Finance And Investment

The rate of return for an Australian Commonwealth Government Treasury Bond is given as 4% per annum. The yearly return for the Australian share market is given as 12%. Suppose a listed company has a beta value of 0.75. The dividend payments for the listed company are expected to grow at 4% per year. The current dividend is $3 per share.

(a) Calculate the market premium.

The formula for calculating risk premium is to calculate the return or income on the investment less the return or income that would be earned on a risk free investment.

Risk-Free rate = 4% (Normally pegged on the Australian commonwealth Gov.T-Bonds)

Stock’s rate of return = $3

Market rate of return = 12%

= Risk Premium = Stocks rate of return – Risk Free rate

= 3 – 4 = -1 i.e. these means that the investment will incur a loss during these period

Beta = 4-4/12-4

= -0.125 The stock is very volatile as compared to the market.
(b) Calculate the investors’ required rate of return for the company’s shares.

Using beta to calculate a stock rate of return = beta *(market rate of return –risk free rate)

Risk free rate = 4%

Market rate of return= 12

Beta = 0.75

0.75(12-4) = 6% + 4% (risk free rate) = 10%

(4 marks)
(c) Calculate the intrinsic price of the shares. (4 marks)

Intrinsic value = 10%-4% = 4%

6% * 3 = $0.18
(d) If the market price is $50 per share, would you buy shares in the company? Explain your answer. (2 marks)

Yes. The beta = 50 – 4/12- 4 = 5.75 The stock is very volatile than the market. It will be a good investment. Beta indicates the riskiness of certain stock that’s used to analyze the expected rate or return. High volatility is also associated with high income and also high volatility.

The broadest index on the Australian share market is the All Ordinaries Index.

(a) Define the All Ordinaries Index and explain how the All Ordinaries Index can be used to estimate the market return of the Australian share market. (4 marks)

All ordinaries index derives its name from its meaning i.e. it includes all the oldest ordinary shares in its index calculations. All the shares that are listed in the ASX (Australian Stock Exchange) The ASX value of shares amounts to approximately makes up about 95% of the market Capitalization that are included in the ASX. All the ordinary shares had a base index of 500. It means that if the current index is 5000 points then the value of all the Ords have multiplied ten times since it began trading in January 1980. It was restructured in the year 2000 to include only 500 largest trading companies by their market capitalization.

(b) Construct a table showing the daily closing value of the All Ordinaries Index from September 30, 2013, to October 18, 2013, inclusive. (2 marks)

Month	All Ords Price Index	Month	All Ords Price Index
30-Sep	5217.72	10-Oct	5146.21
1-Oct	5206.27	11-Oct	5228.84
2-Oct	5214.89	12-Oct	5228.84
3-Oct	5232	13-Oct	5206.47
4-Oct	5205.88	14-Oct	5206.47
5-Oct	5205.88	15-Oct	5259.16
6-Oct	5160.61	16-Oct	5264.39
7-Oct	5160.61	17-Oct	5281.88
8-Oct	5148.1	18-Oct	5321.01
9-Oct	5151.55

(c) On your table, show the daily percentage change in the All Ordinaries Index in this time period, to two decimal places. (4 marks)

Month	All Ords Price Index		Month	All Ords Price Index
30-Sep	5217.72		10-Oct	5146.21	-0.10%
1-Oct	5206.27	-0.22%	11-Oct	5227.84	1.59%
2-Oct	5214.89	0.17%	12-Oct	5228.84	0.02%
3-Oct	5232	0.33%	13-Oct	5206.47	-0.43%
4-Oct	5205.88	-0.50%	14-Oct	5214.47	0.15%
5-Oct	5205.88	0.00%	15-Oct	5259.16	0.86%
6-Oct	5160.61	-0.87%	16-Oct	5264.39	0.10%
7-Oct	5160.61	0.00%	17-Oct	5281.88	0.33%
8-Oct	5148.1	-0.24%	18-Oct	5321.01	0.74%
9-Oct	5151.55	0.07%

(d) Did the All Ordinaries Index show any volatility during this time period and what was the cause of this volatility? (5 marks)

It’s a low volatility relatively high dividend index. The volatility shown were minor as the index Percentages moved to negative figures.

Question 7 (Total marks for this question = 10 marks)
Consider an investment project with a length of n years and an initial outlay IO. Let be the net cash flow for the project in year t, where t = 1, 2, …, n. Let k be the project discount rate per annum, expressed in decimal form. t ACF
Write down a formula for the net present value, NPV, for the project. (2 marks)

NPV = Cash Inflows – Cash Out flows + PV

{IO1/1+k) + IO2/ (1+k) ^2 +IOn/(1+k)^n = IO

NPV = (n∑ t=1) n-1 = OIt/ (1+k) ^t –IO

Write down a formula for the profitability index, PI, for the project. (2 marks)

PI = PV of Annual Cash Flows/Initial Investment.

PI = n∑t=1 *IOt/ (1-k) ^t/IO0

NPV= (n∑t=1) n-1 = OIt/ (1+k) ^t –IO = n∑t=1 *IOt/ (1-k) ^t/IO0

NPV = PI = (n∑t=1) n-1 = OIt/ (1+k) ^t –IO = n∑t=1 *IOt/ (1-k) ^t/IO0

NPV=PI=

NPV = PV of Cash inflows – Initial Investment

PI = PI = PV of Annual Cash Flows/Initial Investment IF Cash flows = t and initial investment = x then NPV = t – n while PI = t/n

t-n = t/n =

(d) Why is the net present value used more than the profitability index in capital budgeting?

The profitability index only supplements the conclusions arrived at after NPV calculations. It’s a relative measure of determining profitability. It’s not consistent in the calculations of mutually exclusive projects. NPV measures the profitability of a project and it provides for the time and value of money. It’s takes care of wealth maximization and satisfies the concept of value-additivity.

Question 10
State whether or not you think the Board of the Reserve Bank of Australia will decrease the cash rate again in the current interest rate cycle. Give reasons for your answer.

In the first quarter of this current year, the Australian GDP improved by 0.5% while it increased by 2.5% in the second Quarter. This trend if fairly favorable to the economy and there is no need to start causing jitters in the market as interest rates are normally affected mostly by what people perceive will happen in future. Changing the interest rates now may cause unwanted effects in the economy which currently does not warrant an increase or decrease in interest rates.

Reference

Levinson, M. (2006). Guide to Financial Markets. London: The Economist (Profile Books). pp. 155–6. ISBN 1-86197-956-8

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