CADANGAN SOALAN MAF 620 – CORPORATE FINANCE

Question 1

Consider the following information about two securities:

State of EconomyProbabilityReturn on Lotek (%)Return on Hitek (%) Recession0.21050

Normal0.51520

Expansion0.325 –10

REQUIRED:

a.Determine the expected return and standard deviation of each security.

(8 marks)

b.Suppose you could invest in only one security. Which would you select, Lotek or Hitek? Why? (2 marks)

c. If the correlation between the returns of Lotek and Hitek is – 0.01, calculate the expected return and standard deviation of a portfolio with 90% invested in Lotek and the balance in Hitek. (6 marks)

d.“The most important factor which determines a portfolio’s expected return and its standard deviation is the expected returns and standard deviations of the individual securities in the portfolio”.

Do you agree?

(4 marks)

(Total : 20 marks)

Question 2

A.Tenat Corp. Bhd is near financial collapse due to accumulated losses in recent years. The firm expects to remain in business for one more year. It is considering between two mutually exclusive projects, whichever chosen will be the only activity for the year. Managers expect equal likelihood of a boom or bust year. Tenat is obligated to pay bondholders RM400,000 at the year end. Ignore taxes and discounting.

The information about the two projects are as follows:

Project AProject B

Economic stateBoomBustBoomBust

Probability0.50.50.50.5

Payoff from ProjectRM600,000RM400,000RM700,000RM100,000

REQUIRED:

i.Calculate for the firm, the company value, and its equity and debt values if Project A is chosen.

(4 marks)

ii.Calculate for the firm, the company value, and its equity and debt values if Project B is chosen.

(4 marks)

iii.Which project do the shareholders want Tenat to accept? Explain.

(4 marks)

B.For each of the following statements below, answer true or false, and give an explanation for your answer. Assume an MM world of perfect capital markets and the absence of taxes.

i.“In such a world, the use of debt will increase the market value of the firm.”

ii.“In such a world, an increase in financial leverage will increase the required return on equity.”

iii.“In such a world, investors can use homemade leverage to achieve the benefits and risks of a levered firm.”

iv.“In such a world, an increase in financial leverage will decrease the weighted average cost of capital.” (8 marks)

(Total: 20 marks)

Question 3

Dragonfly Airlines Bhd plans to expand its fleet with an order of 25 new planes, its CEO, Moktar Salleh, said recently. The order would add to the company’s passenger plane fleet which is South-East Asia’s biggest with about 100 aircraft.

“The new planes will be in service and depreciated over 15 years,” Moktar said, adding that the company forecasts the order to bring in additional revenue of RM45 million annually over the period concerned.

The appropriate discount rate is 12% if the investment is fully equity financed. A corporate tax rate of 25% applies and the risk-free rate is 6%.

Required:

a.If the above estimates are correct, calculate what is the maximum price Dragonfly should be willing to pay for the 25 planes?

(Assume the use of 100 percent equity financing).

(5 marks)

b.Suppose Dragonfly receives a proposal from Airbus-Fortis JV Inc. Airbus, the European aircraft manufacturer, will supply the 25 planes for RM250 million, and will buy back the planes at a salvage value of RM30 million after their 15-year usage. Fortis, an investment bank, will provide a 15-year RM200 million loan at 10% interest. The principal is to be repaid in one lump sum at the end of the loan period. A processing fee...