FINS 1612 homework question for Tutorial in week 7

You don’t need to submit them, but you are encouraged to do them before your tutorial.

Chapter 5

2 Disney Corporation is considering the re-release of its classic film library. The
project will involve an investment of $78 000 000 and will produce a positive
cash flow of $25 000 000 in the first year. The cash flows will increase by 10 per
cent each year thereafter for another five years (i.e. the project runs for six
years). At that stage the project will cease. The company expects a rate of return
of 17 per cent on this type of project.

a. Calculate the NPV and the IRR.

Note: present value = S (1 + i)-n

payments per year = 1

net cash flows: period 0 = -$78 000 000

period 1 = $25 000 000
period 2 = $27 500 000
period 3 = $30 250 000
period 4 = $33 275 000
period 5 = $36 602 500
period 6 = $40 262 750

Because the cash flows are conventional, an IRR can be computed. This can
be undertaken by hand, using a financial calculator or Excel. In Excel,
simply use the IRR function to obtain the answer.
Answer: IRR = 31%
To find the NPV, find the PV of each of the cash flows, add them up and
subtract the $78 000 000 investment. The NPV = $32 491 841.

b. Should the company proceed with this investment opportunity? Why?

• The project has a positive NPV, plus it has an IRR greater than the
required return, therefore the company should proceed with the project.
• The underlying assumptions are that the company is confident with the
cash flow forecasts, and that it knows its required rate of return.

7 Santos Limited has expanded its exploration program and has decided to
fund the expansion through the issue of additional ordinary shares to its
existing shareholders on a pro-rata basis of one new share for each five shares
held. The issue price is $5.75 per share and the current market price is $6.50.
The financial advisers to the corporation have recommended the use of an
underwriting facility. The board of directors has noted that the underwriting
facility has an out-clause if the market price drops below $5.50. Using this
information, answer these questions.

a. What type of issue is Santos Limited making to its shareholders?

• The issue by Santos Limited of additional ordinary shares to existing

shareholders at a ratio to the existing shareholding is a pro-rata rights
issue.
• In the above example the shareholder will receive one new share for each
five shares currently held. The new rights shares will be issued at $5.75
each.
• The issue price of $5.75 is at a discount to the current market price, partly
as an incentive to shareholders and partly to allow for the expected fall in
the price due to the dilution effect of the additional new shares.
• The right may be renounceable and listed on the stock exchange; the
shareholder is entitled to sell that right before the exercise date;
otherwise the right may be non-renounceable.

b. What is an underwriting facility, and why might Santos use such a facility?

A contractual undertaking by an underwriter to purchase securities that

are not fully subscribed to by the existing shareholders; for example, the
 underwriter has agreed to buy any surplus Santos rights issue shares
providing the market price remains above $5.5.
In a large issue of securities there will typically be a group of
underwriters and sub-underwriters, each accepting a portion of the
underwriting exposure.
The underwriters will charge a fee for this service.

Why might Santos use an underwriter?

• The underwriters will provide advice on:

o the structure, pricing, timing and marketing of the issue

o the allocation of the securities between underwriters, investors
and markets.

• Underwriting an issue provides the corporation with a much higher level

of certainty that it will raise the necessary funds from the issue,
particularly in times of market volatility.

c. What is the out-clause entered into by Santos? Discuss how the out-clause
operates.

• An out-clause is usually incorporated in an underwriting facility.

• Specified conditions, situations or benchmarks will activate the out-clause
and preclude the underwriting agreement from being enforced; for
example, an out-clause may relate to a specified change in a published
share market index.
• In the example, the underwriter has an out if the Santos share price falls
below $5.5.

8 Rio Tinto Limited has decided to sell its shale coal part of the business by
establishing a new limited liability company to be known as Shoal Limited.
Shoal Limited will be a listed corporation on the ASX. Rio Tinto and Shoal
decide to issue the new shares at $2.65, but through the issue of instalment
receipts. An initial payment of $1.25 is payable on application and a final
payment of $1.40 is due 12 months later.

a. Shoal Limited will be a limited liability company. What are the rights and
financial obligations of shareholders that purchase shares in the company?

• Holders of ordinary shares have the right to vote for directors of the
board, plus any other motions that may be put to a general meeting of
shareholders.
• Shareholders have a residual claim on the assets of the firm after all other
creditors have been paid.
• Shareholders typically receive dividend payments, usually twice-yearly,
distributed from the profits of the corporation.
• As Shoal is a limited liability company, the claims of creditors against
shareholders are limited to the value of the fully paid ordinary shares
issued; for example, as Shoal has issued partly paid shares (instalment
receipts), then the shareholders are required to make the outstanding
instalment payment on the unpaid portion when due.
• The holder of shares in a limited liability company cannot be forced to pay
further monies to the corporation or its creditors.

b. The company has decided to structure the issue using instalment receipts.
Explain how instalment receipts operate and why the company may have
decided on this strategy.

• Shoal Limited has issued instalment receipts. These are issued upon
payment of the first instalment ($1.25) towards the purchase of ordinary
shares in the corporation.
• When the final instalment of $1.40 is paid the investor will receive the
ordinary share of the company.
• The instalment receipt holder usually retains the same rights as a
shareholder, including the receipt of any future dividend payments.
 • The company may have decided to issue instalment receipts as this may
be more attractive to potential investors (shareholders) in that the full
amount does not need to be paid immediately. Also, the company may not
require the use of the full amount of funds until the business is fully
operational, and the instalment receipt structure can be designed to meet
forecast cash flow requirements.

11 JB Hi-Fi is expanding its retail operations and seeks to raise capital to do so.
The company advisers recommend the board of directors choose between a
pro-rata rights issue or a private placement. Explain each of these funding
alternatives and discuss the advantages and disadvantages of each alternative.

JB Hi-Fi has the advantage of an established positive reputation which will

enable it to raise further equity funding.

1. The choice is between a pro-rata rights issue and a placement; both relate
to the issue of additional ordinary shares.

Rights issue:

• A pro-rata rights issue occurs when existing shareholders are given an

entitlement to subscribe for additional shares in the company.
• In making a rights issue, the company must ensure that all shareholders
receive an equivalent opportunity to participate in the issue. This is
achieved by making the offer on the basis of a fixed ratio of new shares to
the number of existing shares held (pro-rata basis). For example, a 1:10
(one for ten) offer gives a shareholder the right to purchase one new share
for every ten existing shares held.
• Often a rights issue is renounceable, that is, the shareholder is able to sell
the option (right) to another party, but some issues are non-renounceable
(cannot be sold).
• An advantage of a rights issue is that the company retains its existing
shareholder base, and at the same time is able to raise additional equity
funding.
 • A rights issue must conform to the prospectus requirements of
the Corporations Act and this can be costly and time consuming.
• The time lag between the pricing of the issue and the actual issue date
exposes the company to pricing risk, that is, the share price might fall
below the rights price.

Placements:

• A placement is an arrangement where a company may issue additional

shares, with shareholder approval, directly to selected institutional and
individual investors who are deemed to be clients of brokers, without the
need to register a prospectus.
• Subscriptions must be for not less than $500,000 and to not more than 20
participants.
• The advantages to the company include the reduced compliance costs (no
prospectus, only an information memorandum), the quickness in which the
issue can be finalised, often at a lower discount to market price, and to
investors that are friendly to the company.
• A disadvantage to existing shareholders is ownership dilution; however
placements are restricted to a maximum of 15% of capital in any 12-month
period.

Chapter 6

End-chapter essay questions:

10 A company with a lower P/E ratio is a better investment than a company

with a higher P/E ratio. Discuss this statement.

In general, a lower P/E ratio is a signal of ‘better value’. The investor who
invests in a lower P/E stock is paying less for each dollar of earnings.

• As such, we might say that a company with a lower P/E is a better

investment.
• However, there are a few things to consider. First, the low price might be
completely justified and earnings might be expected to fall. As such, while
the P/E ratio is low in the short term, it may increase as earnings decline.
Second, although a company might currently have a high P/E ratio, this
higher price might be completely justified by the positive outlook for the
company. As earnings increase, the high P/E ratio comes to look more and
more appropriate. Indeed, if earnings increase faster than the share price,
the P/E ratio will fall.
• Low P/E ratios might be indicators of value but more investigation is
required in each individual case.

12 The last dividend paid to shareholders by Vicinity Centres was $0.10 per
share. Assume that the board of directors of the company plans to maintain a
constant dividend growth policy of 7.00 per cent. An investor, in evaluating an
investment in the company, has determined that she would require a 12 per
cent rate of return from this type of investment. If the current price of Vicinity
shares in the stock market is $4.00, should the investor purchase the shares?
(Show your calculations.)

• Vicinity is planning to maintain constant dividend growth. Therefore, the

next dividend paid will be the last dividend multiplied by the growth rate:

𝑃0 = 𝐷0 (1 + 𝑔)/(𝑟𝑠 − 𝑔)
= 0.10 (1.07)/(0.12 − 0.07)
= $2.14

• At a current market price of $4.00 the investor should not consider buying
the shares based on this simple analysis. Rather, to justify a purchase at
$4.00, the required rate of return must be lower or the growth rate of the
dividends must be higher.
13 AGL Energy Limited has declared a $0.33 cents per share dividend, payable
in one month. At the same time the company has decided to capitalise reserves
through a one-for-three bonus issue. The current share price at the close of
business on the final cum-dividend date is $16.15.

a. Explain the strategy adopted by the company. In your answer, define the
terms ‘cum-dividend’ and ‘ex-dividend’.

• The company wishes to restructure its balance sheet by converting

reserves into ordinary shares through the provision of bonus shares to
existing shareholders.
o assumption: dividend is not payable on bonus share issue
o cum-dividend—the situation when a share price incorporates an
entitlement to receive a declared dividend
o ex-dividend—the share price after a declared dividend has been paid in
cash to shareholders.

b. Calculate the theoretical price of the share after the bonus issue and the
dividend payment have occurred.

• Calculate the theoretical share price:

cum-dividend share price $16.15

dividend paid 0.33

ex-dividend price $15.82

cum-bonus/ex-dividend price $15.82

market value of 3 cum-bonus shares $47.46

market value of 4 ex-bonus shares $47.46

 theoretical value of ex-dividend/ex-bonus share $11.86

14 Alumina Limited has a share price of $2.82. The company has made a
renounceable rights issue offer to shareholders. The offer is a three-for-ten pro-
rata issue of ordinary shares at $2.60 per share.

a. Explain the effect of the offer being renounceable.

• Rights issue—the issue of additional ordinary shares to existing

shareholders on a pro-rata basis relative to their existing shareholding
• Renounceable—the right is listed on the stock exchange and the
shareholder is entitled to sell the right to a third party rather than
accepting the offer.

b. What is the price of the right?

𝑁(𝑐𝑢𝑚 𝑟𝑖𝑔ℎ𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑠𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒)

𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 =
𝑁+1
where N is the number of shares required to obtain the rights issue share,
and the subscription price is the discounted price of the additional share.
Therefore:
3.3333($2.82 − $2.60)
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 =
4.3333
$0.7333
=
4.3333
= 16.92𝑐𝑒𝑛𝑡𝑠

c. Calculate the theoretical ex-rights share price.

cum-rights share price $ 2.82

Market value of 10 cum-rights shares $28.20

plus:
 new cash introduced through take-up of 3 for 10 issue $ 7.80

gives:

market value of 13 ex-rights shares $36.00

therefore:

theoretical ex-rights share price $ 2.77

d. Explain why an actual ex-rights price of a share may at times differ from the
calculated theoretical price.

• The ex-rights price may not fall to its theoretical value because of the
informational content of the rights issue. The increased equity base may
indicate increased growth and profitability thus allowing the company to
maintain its current dividend rate.

Chapter 7

End-chapter essay questions:

7 An investor is evaluating the use of the bottom-up approach and the top-
down approach to fundamental analysis. The investor wants to use the
approach that will best enable them to structure a diversified share portfolio
that will achieve specified income returns and capital gains. Which approach do
you recommend the investor adopt?

Fundamental analysis requires the adoption of both the top-down approach

and the bottom-up approach.

• The top-down approach analyses macro variables including:

 • the rate of growth of major international economies, and their
governments’ policy responses to developments within those economies
• the exchange rate between a domestic currency and the currencies of
major trading partners and competitors
• interest rate movements
• the rate of growth of the economy
• developments in the current account of the balance of payments
• price rises, as measured by the rate of inflation
• the rate of growth in wages and productivity
• government policy responses to developments in the above variables.

• The bottom-up approach considers factors that reflect or will impact upon
the performance of individual corporations and their share price, including:

• accounting ratios, typically over the past 3 to 5 years

• a comparison of the performance indicators with other similar firms in
the same industry
• intelligence on changes in key management positions
• information on the corporate mission, and planned strategic directions of
the company into the future.

• The top-down approach identifies economies and industries that may

provide profitable investment opportunities in the future; the bottom-up
approach identifies specific corporations with the preferred economies and
industry sectors that may represent stocks to incorporate in an investment
portfolio.
• Both approaches should be used together.

14 a. Briefly outline the main contentions of the efficient market hypothesis. In

your answer, discuss the contentions of the efficient market hypothesis within
the context of technical analysis and fundamental analysis.
• Efficient market hypothesis contends that markets are information-
efficient and that share prices reflect all available information.
• If this is the case extra profits cannot be made from superior information.
• This suggests that the two fundamental analysis approaches will not
achieve higher results. However, there is a need to consider the ability of
market participants to understand, evaluate and interpret that
information.
• The efficient market hypothesis also argues that technical analysis is of no
value as it relies the repetition of past price patterns.
• Share markets are generally information-efficient and prices generally
follow the random walk process and reflect the current available
information.
• Above-normal profits are unlikely to be made by using current
information since it is likely to already be reflected in the price of the
share.
• Nevertheless, for some skilled analysts, and for those able to uncover not-
yet-public information, above-average rates of return may be available.

b. How can the hypothesis be tested? In your response, distinguish between

the weak, semi-strong and strong forms of efficiency.

• The strength of the efficient market hypothesis is related to the level of

efficiency of the markets; that is, how quickly is information absorbed by
the market and reflected in the share price
• There are three measures or levels of efficiency
• Weak form efficiency—share prices changes are independent and not
based on historic data
• Semi-strong form efficiency—all publicly available information is fully
reflected in a share price
• Strong form efficiency—all publicly available information and private
research is fully reflected in a share price.