AB1201

Proposed answers for AB1201 Exam Sem 1 AY2022-23

Section A

Question 1 (10 marks each) (TOTAL 40 marks)

1a)

Part i)

Since both plans have the same present value and same reinvestment rate r%, they will also
have the same value at any time in the future, so you should be indifferent between the two
plans. (Note: We should not assume that the future value of Plan A and Plan B would only be
at the end of 10 years and at infinity, respectively. If we compound the same present value to
any future date using the same reinvestment rate r%, both plans will have the same value at
any same time in the future.)

Part ii)

If “r%” is treated as “the annual rate that you can earn with the money you receive” (i.e., the
discount rate used to compute the present value of the two plans), then the present value of the
two plans will be affected differently. The increased r% would cause a greater reduction in the
present value of the perpetuity for Plan B compared to that of Plan A (because distant cash
flows in the perpetuity will be discounted many periods). Consequently, Plan A will have a
higher present value and hence be more attractive than Plan B.

(However, some students may interpret “r%” as “the discount rate at which the two plans have
the same present value”, in which case you will be indifferent between the two plans.)

1b)

Part i)

The firm-specific risk refers to the risk that is unique to the stock or company, while systemic
risk or market risk refers to the risk that is common to all stocks. Also, firm-specific risk is the
component of the stand-alone risk that can be diversified away, while systemic risk is not
diversifiable. Examples: The health and mental well-being of Elon Musk is a firm-specific risk
for Tesla, and the likelihood of an economic recession is a systemic risk that affects all stocks.

Part ii)

Students need to illustrate that (1) the decline in portfolio’s stand-alone risk is attributed to the
diversification of firm-specific risks and (2) portfolio’s stand-alone risk will not decline to zero
because the portfolio’s systemic risk cannot be diversified away, regardless of the number of
stocks added to the portfolio, since all stocks are exposed to same systemic risk.

1c)

Part i)

Stock Market Equilibrium is the state in which stock prices are equal to their intrinsic values.

Part ii)
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Stock Market Efficiency is the extent to which stock prices are close to their intrinsic values
and the stocks seem to be in equilibrium.

The possible implications of an efficient stock market are:

- Stock prices are fairly priced at all times.
- It is not possible to identify undervalued stocks by analyzing published data on the
stocks.
- An investor can beat the market only with luck or inside information.
- It is better to invest in an index fund designed to match the performance of the overall
stock market.

1d)

Part i)

NPV profile is a graphical representation of a project NPVs at different costs of capital.

When two NPV profiles cross, it reflects the different sensitivity of their NPVs to the changes
in the discount rate. The two possible causes of this are the “difference in the timing of the cash
flows” and the “difference in investment size” for the two projects.

Part ii)

The IRR and NPV methods always lead to the same accept/reject decision when the project is
independent and has normal cash flows. When the NPV of a project is positive, its IRR would
be greater than the WACC, and when the NPV of a project negative, its IRR would be less than
the WACC.

For mutually exclusive projects with different size (different scale) and/or different timing of
the cash flows, if the discount rate is greater than the crossover rate, the IRR and NPV methods
will lead to the same choice of project, and there will be no conflict. However, if the discount
rate is less than the crossover rate, the IRR and NPV methods will lead to different choices of
project.

The NPV method is better than the IRR method because:

1. The reinvestment rate assumption of WACC in the NPV method is more realistic than
the IRR reinvestment rate assumption in the IRR method.
2. The NPV method directly measures the dollar increase in shareholders’ wealth, whereas
the IRR method does not give us such information.
3. If an independent project has non-normal cash flows, the IRR method may result in
multiple-IRR problem, whereas the NPV method does not have a problem handling
non-normal cash flows.
4. The NPV method can be used for mutually exclusive projects with different scale or
different pattern of cash flows, whereas the IRR method may lead to wrong choice of
project under such a situation.
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Section B

Question 2 (TOTAL 15 marks)

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a) 6.60%
Let x be the weightage invested in stock C.

𝑥 + 3𝑥 = 1 − 0.3

𝑥 = 0.175 or 17.50%

17.50% × 3 = 52.50% invested in stock A, 30% invested in stock B, and 17.50% invested
in stock C.

𝐸(𝑅𝑃 ) = (4% ∗ 0.525) + (8% ∗ 0.3) + (12% ∗ 0.175) = 𝟔. 𝟔𝟎%

______________

b) $𝟓, 𝟏𝟎𝟎
𝑃𝑀𝑇 100
𝑃𝑉 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = = 2.% = 5,000
𝐼
100
𝑃𝑉 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑑𝑢𝑒 = + 100 = 5,100
2%
_______________

c) 12.20%

rS = D1/P0 + g = (2×1.05)/21 + 0.05 = 15.00%

WACC = (0.4×10%)(1-0.20) +(0.6×15%) = 12.20%

________________

d) $61,309

𝑇𝑉 (𝑖𝑛𝑓𝑙𝑜𝑤𝑠)
PV of outflows = (1+𝑀𝐼𝑅𝑅)𝑁

10,000(1.1)3 + 15,000(1.10)2 + 30,000(1.1) + 40,000

𝐶𝑜𝑠𝑡 =
(1 + 𝑀𝐼𝑅𝑅)4

104,460
𝐶𝑜𝑠𝑡 = = $61,309
(1 + 0.1425)4
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e) 1.44

After recapitalisation, rS = 16.04% = 5% + (6%) bL,40%

bL,40% = 1.84

0.40
𝑏𝐿 = 1.84 = 𝑏𝑢 [1 + ( ) (1 − 0.20)]
0.60

bU = 1.20

0.20
𝑏𝐿,20% = 1.20 [1 + ( ) (1 − 0.20)]
0.80

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bL,20% = 1.44
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Section C

Question 3 (TOTAL: 15 marks)

a) (5 marks)
0 r 1 2 11 12
|-------------|-------------|------ -- -- -- --------|-------------|
1,000 1,000 1,000 1,000

r = (1 + 10%/360)30 – 1 = 0.8367%

FV = 1,000[(1 + 0.8367%)12 – 1] / 0.8367% = $12,567.92

b) (10 marks)
Since FV is proportional to PMT, the year-end FV every year will also grow at the same
5% annual perpetual rate.

0 R 1 2
|-----------------------|-----------------------|-------- -- -- -- -------> ∞
PV = ? g=5% 12,567.92 12,567.92(1+5%)

EAR = (1 + 10%/360)360 – 1 = 10.5156%

Using Gordon formula to compute the PV of the growing perpetuity:

PV = 12,567.92 / (10.5156% - 5%) = $227,863.04

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Question 4 (TOTAL 10 marks)

a) (5 marks)

Annual coupon = 9%(1,000) = $90

Find the FV (at t=3) of all coupons (using 3% annual reinvestment rate) and par:

FV = 90(1 + 3%)2 + 90(1 + 3%) + 90 +1,000

= 95.4810 + 92.70 +1,090

= $1,278.181

Find the actual r by equating PV of cash outflows and PV of cash inflows:

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1,278.181
990 =
(1 + 𝑟)3
1,278.181
(1 + 𝑟)3 = 990

1,278.181 1
Actual total return (p.a.) = ( 990
)3 − 1 = 8.889%

b) (5 marks)
D0 = $1
beta = 1.2
rRF 4%
MRP = 5.5%
g 3%
rs = rRF + b(RPM) = 4% + 5.5%(1.2); 10.60%
E(P1) = D2/(rs − g) = 1×(1.03)2/(0.106 – 0.03); $13.96

Market P0 $20
E(DY) = D1/P0 = 1.03/20; 5.15%
E(CGY) = [E(P1) / P0] – 1= [20/13.96]-1; -30.2%
E(r) = E(DY) + E(CGY) -25.05%

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Question 5 (TOTAL 10 marks)

Initial cashflow:
Current book value of old machine = (640,000/8) × 5 = $400,000

Tax on gains from sale of the old machine = (410,000 - 400,000) × (0.3) = $3,000

After-tax cash flow from sale of old machine = 410,000 – 3,000 = $407,000

Cost of buying new machine: -$500,000

Total initial cash flow is: -500,000 + 407,000 = -$93,000

Operational Cash flow:

(Income - Expenses) × (1-T) + Depreciation × T

Old machine:

Annual depreciation = 640,000/8 = $80,000

OCFs:
(10,000 × (30 - 10) - 14,000) × (1 - 0.3) + 80,000 × 0.3 = $154,200

New machine:

Annual depreciation = 500,000/5 = $100,000

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OCFs
(15,000 × (30 - 8) - 15,000) × (1 - 0.3) + 100,000 × 0.3 = $250,500

The annual incremental CF is: 250,500 - 154,200 = $96,300

Terminal cash flow: Zero

The NPV of the replacement is

96,300
𝑁𝑃𝑉 = −93,000 + (1 − 1.1−5 ) = $𝟐𝟕𝟐, 𝟎𝟓𝟐. 𝟕𝟕
0.1

Since the NPV of the project is positive, the company should replace its current machine with
the new one.
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Question 6 (TOTAL 10 marks)

3
The stock price after the split will be (80 × 5)(1 + 1.05) = $50.40

1.20 1.35 [1.35(1.06)] 𝑃3

50.40 = + 2
+ 3
+
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)3

50.40 = 1.090909 + 1.115702 + 1.075131 + (P3/1.331)

47.118258 = (P3/1.331)

P3 = $62.71

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