MAF603 – DEC 2015

MAF 603 SUGGESTED SOLUTIONS

SOLUTION 1

A. i. RA = 0.6(20) √ + 0.3(-15) √ + 0.1(40) √ =11.5%√

SDA = √0.6(20%- 11.5%)2 √√+ 0.3(-15%-11.5%) 2 √√+ 0.1(40%-11.5%) 2 √√

=18.31%
( 10√ x ½ =5 marks)
ii. a. β A = (0.7)(0.1831) √ = 1.28
0.10√

β B = (0.3)(0.25) √ = 0.75
0.10√

CAPM: RI = Rf + Bi(Rm – Rf)

Stock A : RA = 4%√ + 1.28 (16% - 4%) √ = 19.36%

Stock B : RB = 4%√ + 0.75 (16% - 4%) √ = 13%
Evaluation:
Stock A is overvalued because its expected return is less than the CAPM return. √

Stock B is undervalued because its expected return exceeds the CAPM return. √
(10√ x ½ = 5 marks)

b. As a risk-averse investor, since stock A is overvalued, √ I do not recommend

investing in this stock as the price is expected to fall in the near future. √ I recommend
investing in stock B√ as it is the better investment because it is undervalued √ and the
price is expected to increase in the near future. √
(5√ x 1 = 5 marks)

B. Yes. √ Diversification is beneficial but it can only reduce unsystematic or firm-specific

risk. It cannot remove systematic risk or market-related risk because this type of risk
originates from market factors which affects all investments, and is not diversifiable. √√
One example for systematic risk is inflation risk. An example of unsystematic risk is
business risk. √√
(5√ x 1 = 5 marks)
(Total: 20 marks)

SOLUTION 2

A. i. Two empirical challenges to EMH:

a. Earnings surprises – Kolanski and Li rank firms by the extent of their earnings
surprises, that is the difference between current quarterly earnings and
quarterly earnings four quarters ago, divided by the current stock price.
These represent a portfolio of companies with the most extreme positive
surprises and a portfolio of companies with the most extreme negative
surprises. It can be seen that prices adjust slowly to earnings
announcements, where the portfolio with positive surprises outperforms the
portfolio with negative surprises. √√√

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 MAF603 – DEC 2015

b. Size – Stock market studies in the US have found that the returns on stocks
with small market capitalizations are greater than the returns on stocks with
large market capitalizations. The studies have since been replicated in other
countries. √√
(5√ x 1 = 5 marks)

ii. a. Violates√ √all the 3 forms of the EMH which are weak form, semi-strong
form and strong form. √√

b. Violates√√ the semi-strong and strong forms of the EMH. √

c. Supports√√ the semi-strong and strong forms of the EMH. √

(10√ x 1/2 = 5 marks)

B. i. The Malaysian ringgit will weaken to the US dollar as it will take more ringgit to
purchase a dollar. √√
(2√ x 1 = 2 marks)

ii. The international investor should invest in Singapore as he will obtain a higher
return in US dollars for his investment. √√
(2√ x 1 = 2 marks)

iii. The Philippine peso will depreciate in relation to the US dollar and the Japanese
yen as the cost of its imports will be greater than its exports resulting in the country
having to borrow from foreign sources to cover its deficit. √√√
(3√ x 1 = 3 marks)

iv. The UK multinational should invest in Hungary instead of Ukraine as Ukraine is

facing a civil war and is not as politically stable as Hungary. This will result in the
currency in Hungary being more stable as compared with the currency in Ukraine. √√√
(3√ x 1 = 3 marks)
(Total: 20 marks)

SOLUTION 3
A
i. a. VL = VU = EBIT = RM500,000√ =RM3,333,333.33 √
rwacc 0.15√

b. Since Debt/Equity = 0.25, we know D = 0.25

D/D +E= 0.25E/0.25E + E
D = 20%√√√

Equity value will be 80%√ x RM3,333,333√= RM2,666,666.67

(8√ x ½ = 4 marks)

ii. a. VL = VU + TcB
= RM500,000 (0.75) √ √ + 0.25( RM800,000) √√
0.20 √
= RM2,075,000

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 MAF603 – DEC 2015

b. Equity Value = VL – B
=RM2,075,000√ – RM800,000√ = RM1,275,000√

c. rwacc = RM500,000 (0.75) √ √

RM2,075,000√
= 18.07%√
(12 √x ½ = 6 marks)

B.. Two implications of MM Prop II in a world with corporate taxes for a levered firm:
a. Rs increases√√ at a lower rate because the firm pays less tax√√ as interest is tax
deductible. √
b. Rwacc will drop √ because when the tax shield increases with the level of debt, √√ the
cost of debt becomes cheaper. √ Therefore, the value of the levered firm will increase. √

(10√ x ½ = 5 marks)

C. Three assumptions used in the Modigliani-Miller Proposition in a world without taxes.

i. No taxes. √ Both corporate taxes and personal taxes are ignored. √√√
ii. No transaction costs. √
iii. Individuals and corporations borrow at the same rate. √√ Through homemade
leverage individuals can either duplicate or undo the effects of corporate
leverage√√√

( 10√ x 1/2= 5 marks)

(Total: 20 marks)

SOLUTION 4

i. NPV (Base Case) = -IO + PV Depreciation Tax shield + PV of cash flow

= -320m√ + ((320m) / 10√) (0.25) (A4%,10y)√ – 50m√ (1 – 0.25) (P14%,1y)√

- 30m√(1– 0.25)(A14%,3y– P14%,1y)√+(150m -10m√)(1 – 0.25)(A14%,10y- A14%, 3y√)
= -320m + ((320m) / 10) (0.25) (8.1109) – 50m (1 – 0.25) (0.8772)
- 30m (1 – 0.25) (2.3216 – 0.8772) + (150m -10m) (1 – 0.25) (5.2161- 2.3216)
= -320m + 64.8872m – 32.895m – 32.499m + 303.9225m
= - RM16.5843m√
(10√ x 1/2 = 5 marks)
ii. APV:
Floatation Cost = 320 x 2% =6.4m
NPV (FC) = -6.4m√ + 6.4m/10√(0.25) (A4%,10y)√
= -6.4m + 6.4m/10(0.25)(8.1109)
= -RM5.102256m

NPV (Loan) = 320m√ – 320m(0.07) √ (1 – 0.25) (A7%,5y)√ – 160√ (P7%,5y)√

-160m (0.07) √ (1 – 0.25) (A7%,10y-A7%,5y√) – 160√ (P7%,10y)√
=320m – 320m (0.07) (1 – 0.25) (4.1002) – 160 (0.7130)
-160m (0.07) (1 – 0.25) (7.0236 – 4.1002) – 160 (0.5083)
=320m – 68.88336m – 114.08m – 24.55656m – 81.328m
= RM31.15208m

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 MAF603 – DEC 2015

APV = - RM16.5843m – RM5.102256m +RM31.15208m

= RM9.465524m√

Decision: Accept the project with debt financing because the APV is positive √
(14√ x 1/2 = 7 marks)

iii.

NPV (Govt Loan) = 320m√ – 320m (0.06) √ (1 – 0.25) (A7%,5y)√ – 100√ (P7%,5y)√
-220m (0.06) √ (1 – 0.25) (A7%,7y-A7%,5y)√ – 220 (P7%,7y)√

=320m – 320m (0.06) (1 – 0.25) (4.1002) – 100 (0.7130)

-220m (0.06) (1 – 0.25) (5.3893 – 4.1002) – 220 (0.6227)

=320m – 59.04288m – 71.3m – 12.76209m – 136.994m

= RM39.90103m

APV = - RM16.5843m + RM39.90103m

= RM23.31673m√

Decision: Accept the project with debt financing from the government because the APV is
higher than borrowing from the commercial bank.√
(10√ x 1/2 =5 marks)

iv. Sensitivity analysis also known as what-if analysis, examines how sensitive a particular
NPV calculation is to changes in the underlying assumptions, where one variable is examined
over a broad range of values. √√√ Scenario analysis examines a number of different likely
scenarios where each scenario involves a confluence or coming together of factors, that is, all
variables are examined for a limited range of values. √√√
(6√ x ½ = 3 marks)
(Total: 20 marks)

SOLUTION 5

i. V GN = VG + VN + Synergy
=(RM1.70√ x 10√ x 42m) + (RM0.25 x 30√ x 12m√) + RM36m√
=RM714m + RM 90m + RM36m
=RM840m√
(6√ x ½ = 3 marks)
ii. a. New shares = 12m/2 √= 6m

NPV = Synergy – Premium

= RM36m√ – ( ( 6m x 840m√ ) - 90m√)
48m√
= RM21m√
(6√ x ½ = 3 marks)

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 MAF603 – DEC 2015

b. % owned by new shareholders in combined firm = 6m x 100% = 12.5%√√

48m

(2√ x 1 = 2 marks)

iii. Estimated MP/share after merger = RM840m

48m

= RM17.50/share√√
(2√ x 1= 2 marks)

iv. Original shareholders and new shareholders gain the NPV of the merger√ √of RM21m
√ according to their % holding in the merged firm. √
In addition new shareholders gain the Premium received of RM15m√
(5√ x 1 = 5 marks)

v. Mergers between competitors in the same industry are better √as they are more likely to
result in synergies due to cost reduction in common activities and increase in market
share√√ but, mergers between unrelated companies are difficult to justify√ as they are
not likely to produce synergies. √
(5√ x 1 = 5 marks)
(Total: 20 marks)

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