Question 1 (capital budgeting)

You have been engaged by BBX Bhd to analyze a potential new

product- a special compound developed for use in the residential
construction industry. Based on the market survey conducted by
the marketing manager of the company, it is estimated that 124,500
tubes per year at a price of RM6 each for five years can be sold,
after which the product will become obsolete. The required
equipment would cost RM500,000, plus another RM50,000 for
shipping and installation. Current assets (receivables and
inventories) would increase by RM70,000, while current liabilities
(accounts payable and accruals) would rise by RM30,000. Variable
costs would be RM448,200 per year and the fixed assets is
depreciated using a straight-line method. When the production
ceases after 5 years, the equipment should have a market value of
RM30,000.
To purchase the equipment, the company would have to borrow
RM200,000 from RHB Bank and the interest rate charged is 8.5
percent.
The company’s cost of capital is 10 percent and the corporate tax
rate is 26 percent. Assume that depreciation allowance for
accounting purposes and tax purposes is the same and tax rate is
paid in the year in which income is earned.
Required:
a. What is the initial cash outlay for the new machine?

b. Determine the operating cash flows for years 1-5.

c. Determine the terminal cash flow.

Question 2- Stock valuation

a. You are considering an investment in SMPC’s stock which is
expected to pay a dividend of RM0.30 a share at the end of
the year (D1 = RM0.30) and has a beta of 0.85. The risk-free
rate is 5 percent and the market risk premium is 7 percent.
Currently the stock of SMPC is selling for RM5 a share and
its dividend is expected to grow at some constant g.
Assuming the market is in equilibrium, what does the market
believe will be the stock price at the end of 2 years (P2)?

b. Your broker offers to sell some shares of TE common stock

that paid a dividend of RM0.40 yesterday. TE’s dividend is
expected to grow at 20 percent for 2 years followed by a
constant rate of 5 percent thereafter. The required return is 12
percent. What is the stock’s value per share you are willing to
buy from him?

c. Discuss the weaknesses of dividend discounted model in

stock valuation.
Question 3
a. Stock Q has a 10 percent expected return, a beta coefficient
of 1 and a 30 percent standard deviation of expected returns.
Stock R has 12.5 percent expected return, a beta of coefficient
of 1.5 and a 25 percent standard deviation. The risk free rate is 5
percent and the market risk premium is 6 percent.

Required:

i. Determine the coefficient of variation for each stock.

ii. Which stock is riskier for a diversified investor? Why?
iii.Calculate the required rate of return for each stock.
iv.On the basis of the two stocks’ expected and required returns,
which stock would be more attractive to a diversified
investor? Why?
v. If RM50,000 is invested in stock Q and RM100,000 invested
in stock R, what is the required return of this portfolio?

b. Explain what is Capital Asset Pricing Model (CAPM).