JCU-MBA-Corporate Finance

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Student Name:

Case (maximum possible marks) Marks

Risk and Return, CAPM
Question 1 (2 marks)
Question 2 (3 marks)
Question 3 (3 marks)
Question 4 (3 marks)
Question 5 (4 marks)
Question 6 (3 marks)
Question 7 (3 marks)
Total (21 marks)
DCF & Capital Budgeting Techniques
Question 1 (1 mark)
Question 2 (2 marks)
Question 3 (3 marks)
Question 4 (4 marks)
Question 5 (3 marks)
Total (13 marks)
WACC
Question 1 (2 marks)
Question 2 (2 marks)
Question 3 (2 marks)
Question 4 (2 marks)
Question 5 (3 marks)
Question 6 (3 marks)
Question 7 (2 marks)
Total (16 marks)
Assignment Total (50 marks)

This assignment is worth 25% and thus represents a major component of the assessment
of this course. You should therefore appropriately research and answer each question.

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Mini Case Study Risk

Return, Risk and the Security Market Line

We know that the greater the risk we incur through an investment or business venture, the
greater our expected return. Our reward for incurring extra risk is a risk premium on our
asset.

The risk-return relationship exists in capital markets. Risk occurs when dealing with
securities, whether they are individual securities or portfolios, because their volatility
produces a variance in their returns, causing a deviation from the expected returns to the
actual returns. Factors that can influence such a variance in the actual value of the
security include the market’s knowledge of factors that influence the security, company
announcements and news in relation to the industry surrounding the particular security.

Risk is not simply a factor that is out of a person’s control. Risk can be divided into two
forms: non-systematic risk (diversifiable risk) and systematic risk (non-diversifiable risk).
Non-systematic risk is risk that affects at most a small number of assets—these are risks
to individual companies or assets. On the other hand, systematic risk is risk that
influences a large number of assets. Systematic risk is also called market risk and is the
most important risk to consider.

Our summary of risk would not be complete without an overview of the elements of
diversification. The common phrase ‘don’t place all your eggs in one basket’ arises out of
the concept of diversification. Diversification is the principle stating that spreading an
investment across a number of assets will eliminate some, but not all, of the risk. To
clarify this statement with respect to systematic and non-systematic risk we can conclude
that diversification will only eliminate non-systematic risk, as this is the only risk that is
diversifiable. The risk of systematic risk remains. The measurement of systematic risk
can be represented by the beta coefficient, which measures the amount of systematic risk
present in a particular risky asset relative to an average risky asset.

One of the most important concepts with respect to this chapter is what is known as the
security market line (SML). The security market line brings together the concepts of
systematic risk and expected return diagrammatically. The security market line can be
described as a positively sloped straight line displaying the relationship between expected
return and beta.

The equation for the SML can be written as:

E ( Ri )  R f  [ E ( RM )  R f ]   i

This result is identical to the famous capital asset pricing model (CAPM). What the
CAPM shows is that the expected return for a particular asset depends on three things:

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 The pure time value of money—as measured by the risk-free rate, R f .

 The reward for bearing systematic risk—as measured by the market risk premium,
[ E ( RM )  R f ].
 The amount of systematic risk—as measured by beta,  i .

Figure 11.6 from Ross, Thompson & Others summarises the discussion of the SML and
the CAPM.

The concepts of risk and return provide a stable basis for further discussions based
around long-term capital purchases and investment decisions with respect to company
structure.

The article ‘The spread that covers your crust’ from The Sydney Morning Herald* on 5
May 2007 provides information about how investors should diversify to improve returns.

Considering the above information and the article from The Sydney Morning Herald,
complete the following seven questions.

Question 1
Discuss how risk is associated with the variances on an asset’s expected return. What are
some of the factors that come into play with respect to changes in the price of a particular
security in the market? (2 marks)

Question 2
What is risk with respect to investment? Identify the two types of risk and discuss each
one. Which is the most important type of risk? Why can only one type of risk be
mitigated or eliminated? (3 marks)

*
See file ‘Mini Case Risk article’.

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Question 3
What is beta? How does beta relate to systematic risk? (3 marks)

Question 4
What is the SML? What is the CAPM, and how does the SML relate to the beta
coefficient? (Your answer should include some graphical presentation.) (3 marks)

Question 5
Using the article from The Sydney Morning Herald, discuss how diversification is used to
bring about a positive outcome for retail investors. Why do investment portfolios with
different asset classes need to be continually monitored? What are some alternative asset
classes that investors can diversify into? (4 marks)

Question 6
Assume that you have the betas of all the companies listed on the ASX. Now you select
20 shares based on their betas and, by investing an equal amount in each share, you create
a portfolio with a beta of 1.1. You make sure you select shares with betas ranging in
value from 0.4 to 2.4. (3 marks)

i. Is this likely to be an efficient portfolio?

ii. Is the portfolio likely to be well diversified?
iii. Is the portfolio likely to have much non-systematic risk?

Question 7
Discuss the role of risk in modern portfolio theory. (3 marks)

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Mini Case Study DCF

Net Present Value and Other Investment Criteria

As we have already established, the manager’s main aim is to maximise shareholder

wealth. In order to maximise shareholder wealth, managers must choose investments that
will increase the return to their shareholders and the value of the firm. Investments must
be chosen that will provide value to the owners.

There are numerous measures that allow a firm to establish the viability of a project.
These measures include the payback period—which is considered the most simplistic
measure; however, it does not take into account the discount value of future cash flows—
the discounted payback period, the accounting rate of return, the NPV and the IRR.
While all these methods have advantages and disadvantages, the NPV and the IRR are
among the most accurate and provide the most relevant information.

Shareholder wealth or value can be created by choosing investments that have a positive
NPV—that is, the value of the investment in today’s dollars outweighs the costs of the
investment also calculated in today’s dollars. For an investment decision to be considered
viable, the NPV value must be positive, because only when the NPV value is positive
will the desired investment add any value to the firm. The NPV can be described as the
measure of how much value is created or added by undertaking this particular investment.

The IRR is a measure that is linked quite closely with the NPV, and it is also considered a
desirable measure in relation to the viability of an investment decision. The IRR can be
described as the discount rate that makes the NPV of an investment zero. When using the
IRR method as a choice for investment decisions, we may only select the investments
that produce an IRR figure that is higher than our required return.

The article ‘Discounted cash flow and other valuation tools’ appeared in the Sydney
Morning Herald† on 27 September 2003 and demonstrates the value of discounted cash
flows and their use in predicting which stocks will appreciate in the future. This method
of discounted cash flows allows fund managers to predict the direction of future stocks,
by predicting what their value should be by looking to their future cash flows, discounted
for today. This in turn should provide intrinsic value to the fund shareholders.

Considering the above information and the Sydney Morning Herald article, complete the
following group presentation & shirt write-out questions. Note: Ignore taxation in all
questions.

†
See file ‘Mini Case DCF article’.

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Question 1 (1 mark)
List the methods that a firm can use to evaluate a potential investment.

Question 2 (2 marks)
Why is the NPV a preferred method when evaluating a potential investment opportunity?

Question 3 (3 marks)
What is the IRR? How is it related to the NPV? Is the IRR always an effective method
when evaluating a potential investment opportunity, and why?

Question 4 (4 marks)
Using the article from the Sydney Morning Herald, discuss why John Whiteman, the
senior portfolio manager at AMP Henderson, can be considered ‘skilled’ in respect of his
stock pickings. Why would it benefit fund managers to use discounted cash flows when
picking stocks?

Question 5 (3 marks)
Discuss the role of the time value of money in security valuation.

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MBA Corporate Finance

Mini Case Study - Cost of Capital
One of the most significant concepts in the management of a potential investment is the
establishment of the weighted average cost of capital (WACC). WACC determines the
return a project must earn to cover the cost of the funds used in the investment.
Generally, a firm will accept a project that produces a return greater than the cost of
capital. However, an important concept that we must be aware of is that the cost of
capital depends primarily on the use of the funds, not the source of the funds.

The raising of funds for investment in a firm can be divided into two categories: debt, and
to a lesser extent, preference shares and equity. The cost of equity can be defined as the
return that equity investors require on their investment in the firm. The return is not easily
measured. However, a firm can use the dividend growth model and the security market
line (SML) to estimate the required return and thus the cost of equity. The downfall with
both these approaches is that they focus on historical information, which does not always
hold true.

The cost of debt can be defined as the return that lenders require on the firm’s debt. The
cost of debt is basically the current interest rate in the market. The cost of preference
shares, which are not as popular, is based on the fixed dividend yield paid every period to
the preference shareholders. The cost of debt and preference shares is easier to establish
as they are generally set at fixed rates.

WACC, which can be defined as the weighted average of the costs of debt and equity,
can be looked at in two ways: unadjusted WACC, which does not take taxes into account,
and adjusted WACC, which examines the cost of capital taking into consideration taxes
on funds. The most important measure for a firm is the adjusted WACC as this gives a
true costing of capital funds.

The fundamental idea of WACC is straightforward: it is the overall return that the firm
must earn on its existing assets to maintain the value of its shares. However, while
WACC is an important measure, it still has its drawbacks. On pages 623-625 of the text,
Bernie Wilson (Group Finance Manager of Queensland Rail) sheds some light on the
practical problems of correctly calculating WACC.

Furthermore, WACC can only be used when the proposed investment is similar to the
current operations of the firm. WACC does not take into account the level of risk of the
proposed investment. This element in the real world could a have a great impact on the
profitability of the firm. WACC also ignores that firms may have more than one line of
business (the divisional cost of capital).

There are, however, two strategies that can be used to overcome the above problems: the
pure play approach and the subjective approach.

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If a firm chooses to raise funds through issuing primary securities in the market, we must
remember that the flotation costs need to be taken into account when working out the cost
of capital.

The case article, ‘BOQ acts to reduce cost of capital with debt issue’ in Australian
Banking and Finance‡ on 1 September 2000 discusses the Bank of Queensland’s (BOQ)
attempt to maximise shareholder value through proactive management of the capital base.

Considering the above information and the article from Australian Banking and Finance,
complete the following seven questions.

Question 1
What is the weighted average cost of capital (WACC), and why is it of such importance
to a firm? (2 marks)

Question 2
How is the cost of equity determined? Discuss the methods that can be used.
(2 marks)

Question 3
How is the cost of debt determined? (2 marks)

Question 4
What is the difference between unadjusted WACC and adjusted WACC? Which measure
is more accurate? (2 marks)

Question 5
Using the article from Australian Banking and Finance, discuss how the Bank of
Queensland has changed its financing strategies based on the capital costs of such
financing. (3 marks)

Question 6
Discuss why establishing the cost of capital is important when considering a firm’s
profitability. (3 marks)

Question 7
We know the formula and the variables used in calculating WACC, so what are some of
the practical problems in deriving the correct measure? (2 marks)

‡
See file‘mini case WACC article’.

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