AC/JUNE 2019/MAF603

SUGGESTED SOLUTION

QUESTION 1

a.
Expected Return

RValet = (0.2 x 8%) + (0.5 x 12%) + (0.3 x 16%)

= 12.4%

RPrmus = (0.2 x 5%) + (0.5 x 15%) + (0.3 x 18%)

= 13.9%

Risk
σValet =stddev[0.20(8%-12.4%)2  + 0.50(12%-12.4%)2 + 0.30(16%-
12.4%)2]
= √7.84
= 2.80%

σPrimus = stddev [0.20(5%-13.9%)2 + 0.50(15%-13.9%)2+ 0.30(18%-

13.9%)2]
= √21.49
= 4.64%
(12  x ½ mark = 6 marks)

b. Expected Return Portfolio and Standard Deviation Portfolio consisting of 45% in Valet
Bhd and 55% in Primus Bhd.

RPortfolio = (0.45 x12.4%) + (0.55 x 13.9%)

= 13.225%

σPortfolio = std dev [(0.45)2 (2.80)2  + 2 (0.45)(0.55) (-0.95)  (2.80)  (4.64) 

+ (0.55)2(4.64)2]
= √1.990816
= 1.411%
(8  x ½ mark = 4 marks)

c. Moonbay Bhd should invest in the portolfio investment consisting of 45% in Valet Bhd
and 55% in Primus Bhd  because it has lowest risk (1.411%) at reasonable expected
return which is 13.225%. 

Stocks Expected Return Risk

100% Valet Bhd 12.4% 2.80%
100% Primus Bhd 13.9% 4.64%
45% Valet, 55% Primus 13.225% 1.411%

(2  x 1 mark = 2 marks)

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d. Portfolio required rate return under CAPM.

RValet = Rf + β (RM - Rf)

= 4% + 0.83  (7%)
= 9.81%

RPrimus = Rf + β (RM - Rf)

= 4% + 1.25 (7%)
= 12.75%

RPorfolio = 0.45 (9.81) + 0.55 (12.75) 

= 11.427%

Or

Portfolio Beta = 0.45 (0.83) + 0.55 (1.25)  = 1.061

RPorfolio = Rf + β (RM - Rf)

Portfolio RRPorfolio = 4% + 1.061 (7%) = 11.427%
(6  x ½ mark = 3 marks)

e. Comment on the beta measurement with regards to the sensitivity of each security to a
market-wide risk portfolio.

 Beta measures the responsiveness of security return to the market return. 

 In other words, beta measures how sensitive its underlying revenue and cash
flows to the general economic conditions. 
 A relatively low beta (less than 1) indicated by Hearsay Bhd (0.42) and Valet Bhd
(0.83) means the average stock price tends to move up and down less
sensitive to the systematic risks. Thus, it is more stable and insensitive
to fluctuation in the overall market. 
 The extreme stocks that has higher beta (more than 1) indicated by Primus Bhd
(1.25) and Intel Bhd (2.38), means, its return is affected by the strength of the
economy; boom and busts of the economy as a whole or more sensitive to
systematic risks.  The average stock price tends to rise more than one as
much as the market rise and when market is plummet, it tends to fall more
than one as well. 

Alternative:

 Beta of less than 1 as in Hearsay Bhd (0.42) and Valet Bhd (0.83) means that the
stock ia 58% and 17% less volatile than the market; less sensitive and
less risky. 
 Beta of more than 1 as shown by Primus Bhd (1.25) and Intel Bhd (2.38) means
the stock is 25% and 138% more volatile than the market; highly sensitive
and risky. 
(Any 5  x 1 mark = 5 marks)
(Total = 20 marks)

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QUESTION 2

a. Year 2019: (no taxes, has debt RM1.0 million)

i. Value of company
= EBIT/Ro = 600,000/0.12 = RM5,000,000

Debt = 1,000,000
Equity = 4,000,000

ii. Cost of equity

= Ro + B/S (Ro-Rb)

= 0.12 + [1,000,000/4,000,000] (0.12-0.1) = 12.5%

(6 x ½ marks = 3 marks)

b. Year 2019: assume the pioneer status has expired and corporate tax rate is 24%.

i. VL = EBIT (1-Tc) + TcB

Ro

= 600,000 (0.76) + (0.24)  (1,000,000)  = RM4,040,000

0.12

Debt = 1,000,000
Equity = 3,040,000

ii. Rs = Ro + B/S (Ro-Rb)(1-Tc)

= 0.12 + [1,000,000/3,040,000] ( 0.12-0.1)(1-0.24)  = 12.5%

iii. Weighted average cost of capital

= (B/VL)(Rb)(1-Tc) + (S/VL)(Rs)

=(1,000,000/4,040,000)(0.1) (0.76) +(3,040,000/4,040,000)(0.125)

= 11.29%
(12 x ½ marks = 6 marks)
OR

VL = EBIT (1-Tc)  4,040,000 = 600,000 (0.76)

Rwacc Rwacc

Rwacc = 456,000 / 4,040,000 = 11.29%

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c. Year 2020: pioneer status has expired and corporate tax rate is 24%. Additonal debt
RM1.2 million

i. New VL = Vu + TcB
= 4,040,000 + (0.24) (1,200,000)

= RM4,328,000

Or = 3,800,000 + (0.24)(2,200,000)

= RM4,328,000

Debt = 2,200,000, Equity = 2,128,000, Value = 4,328,000

ii. New Rs = Ro + B/S (Ro-Rb)(1-Tc)

= 0.12 + [2,200,000/2,128,000) ](0.12-0.1) (1-0.24)

= 13.57%

iii. New Weighted average cost of capital (with taxes)

= (B/VL)(Rb)(1-tc) + (S/VL)(Rs)

=[(2,200,000/4,328,000)](0.1)(1-0.24)+[(2,128,000,000/4,328,000)](0.1357)

= 10.54%

OR

VL = EBIT (1-Tc)  4,328,000 = 600,000 (0.76)

Rwacc Rwacc

Rwacc = 456,000 / 4,328,000 = 10.54%

(12 x ½ marks = 6 marks)

d. With the additional debt of RM1,200,000:

i. Value of company increases from RM4,040,000 (Y2019) to RM4,328,000

(Y2020). As debt increases, the company will experience increase in tax
savings or tax shield.

ii. The risk borne by the shareholders will increase due to increase in financial
risk , thus the shareholders may expect higher return. Therefore, cost of
equity also increases from 12.50% (Y2019) to 13.57% (Y2020).

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iii. The overall cost of capital decreases from 11.29% (Y2019) to 10.54%
(Y2020) due to tax implication resulted in cost of debt becomes cheaper.

(Any 5 x 1 mark = 5 marks)

(Total: 20 marks)

QUESTION 3

a. Using Adjusted Present Value (APV) method, evaluate the feasibility of the proposal

NPV (Basic) = – Initial Outlay + PV(Depn. Tax Shield) + PV After tax CF + PV Salvage Value – PV Working Capital

Initial Outlay = –3.6m

PV (Depn Tax Shield) = + (3.6m - 0.6m)/6 (0.24) (A6,5%;5.0757)  = +0.609084
PV After tax CF = + 1.1m (0.76) (A6,10%;4.3553) = +3.6410308
PV Salvage Value = + 0.6m (P6, 10%,;0.5645)  = +0.3387
PV Working Capital =
1 (0.5)  (0.76) (P1, 10% = 0.9091) 0.345458
2 (0.5)(1.02)  (0.76) (P2, 10% = 0.8264) 0.3203126
3 (0.51)(1.02) (0.76) (P3, 10% = 0.7513) 0.2970279 -1.7304428
4 (0.5202)(1.02) (0.76) (P4, 10% = 0.6830) 0.2754258
5 (0.5306)(1.02) (0.76) (P5, 10% = 0.6209) 0.2553892
6 (0.5412)(1.02) (0.76) (P6, 10% = 0.5645) 0.2368293

*Unlevered cost of equity (r₀) = 5% + 5% = 10%√

NPV (BC) = –3.6m +0.609084 +3.6410308 +0.3387 -1.7304428

= –0.741628

NPV(Floatation Costs) = Floatation Cost + PV (Ammortisation’ Tax Saving)

= – (2% x 1.0m) +(0.02m/1 x 0.24) (P1, 5%;0.9524) 
= – 0.02m +0.0045715
= – 0.0154285

NPV (Loan) = Loan – PV(Net Interest) – PV(Settlement)

= 1.0m –1.0m (0.07)  (1–0.24)(A6, 7%;4.7665) –1.0m (P6,7%;0.6663) 
= 1.0m – 0.2535778 – 0.6663
= RM 0.0801222

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APV = – 0.741628 – 0.0154285 + 0.0801222 = RM – 0.6769343

Decision: Reject the purchase of new machine because the APV is negative

(20 x ½ mark = 10 marks)

b. Adjusted Present Value (APV) assuming the machinery is fully finance through the issuance
of new debentures.

NPV(Floatation Costs) = Floatation Cost + PV (Ammortisation’ Tax Saving)

= – (2% x 3.6m) +(0.072m/1 x 0.24)  (P1, 5%;0.9524) 
= – 0.072m +0.0164574
= – 0.0555426

NPV (Loan) = Loan – PV(Net Interest) – PV(Settlement)

= 3.6m – 3.6m (0.07)  (1–0.24)(A6, 7%;4.7665) –3.6m (P6,7%0.6663) 
= 3.6m – 0.91288 – 2.39868
= RM 0.28844

APV = – 0.741628 – 0.0555426 + 0.28844 = RM – 0.5087306

(8 x ½ mark = 4 marks)

c. The APV increases (lower in deficit/negative APV from RM–0.6769343 to RM

-0.5087306) as the value of machinery costs financed by debentures increase, 
(from 1.0m to 3.6m) which is due to higher NPV of debt financing effects. 

(2 x 1 mark = 2 marks)

d. i. Sensitivity Analysis.  Sensitivity analysis is to examine how sensitive a

particular NPV calculation is to change in underlying assumptions. 

ii. Two limitations of sensitivity analysis are:

 The analysis may unwittingly increase the false sense of security

among managers. 
 The analysis treats each variable in isolation when, in reality, the
different variables are likely to be related. 

(or any other acceptable answers)

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(4 x 1 mark = 4 marks)

(Total: 20 marks)
QUESTION 4

A. HSR Bhd

a. i. Synergy = (RM 420,000 + RM 180,000)/0.12 = RM5m

ii. VHSR pre = Price x unit of shares = RM2.40 x 50m = 120m

Price = P/E x EPS = 8 times x 0.3 = RM2.40
EPS = 15m/50m = 0.3

Or

VHSR pre = P/E x total earnings = 8 times x RM15m = RM120m

r = Do (1+g) + g  P = Do (1+g) Note: P is VHSR pre , Do is dividend per share

P (r - g) g is growth rate, r is new rate of return

RM120m = 0.68 x RM15m (1.0417)

r - 0.0417 

RM120m (r - 0.0417) = RM10.62534m

RM120m r – RM 5.004m = RM10.62534m

r = RM15.62934 = 0.1302
RM120

VHSR after (new growth) = 0.68 x RM15m (1.06)

0.1302 - 0.06 

= 154.01709m

Therefore, Synergy = RM154.01709m – RM120m= RM34.01709m 

Total Synergy= Rm5m + RM 34.01709m= RM39.01709m

(10 x ½ mark = 5 marks)

b. i. NPV (Cash offer) = Synergy – Premium payable (cash- VKTM pre)

= RM39.01709m - [RM52m – RM45m*]
= RM32.01709m

VKTM pre (*) = Price x unit of shares = RM1.50 x 30m = 45m

Price = P/E x EPS = 5 times x 0.3 = RM1.50
EPS = 9m/30m = 0.3

OR: NPV = VKTM after – cost paid @ merger price (cash)

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= RM (45m + 39.01709) – RM52m

= RM32.01709m

ii. NPV (Stock) = Synergy – [Merger Price – VKTM pre]

= RM39.01709m – [RM47.08086m – RM45m]
= RM36.93623m

New shares offer = ½  x 30m = 15m

Merger Price = 15m x (RM120m + RM45m + RM39.01709m)

50m+15m

= 15m/65m x RM204.01709m
= RM47.08086m

OR:
NPV = VKTM after – cost paid @ merger price (stock)
= RM [(45m+39.01709) – 47.08086
= RM84.01709 – 47.08086
= RM36.93623m
(10 x ½ marks = 5 marks)

c. The stock offer is better  because of higher NPV of RM36.93623m  than cash offer
of RM32.01709m.

(2 x 1 mark = 2 marks)

B. Disagree.  Merging of unrelated businesses is not a good reason for the business from
mergers perspective because clearly it has little or no synergy with its core
business. Further there is no exchange of technology, resources and skills to avail
the economies of scale and tax benefit. 

(3 x 1 mark = 3 marks)

C. i. Discuss the impact of “co-insurance effect” on the equity value and debt value.

The “co-insurance effect” raises the value of debt (bondholders) but lower
the equity value (stockholders).  The reason is that the bondholders are
likely to gain from the merger because their debt is now “insured” by two
firms, not just one.  The size of gain to bondholders depends on the riskiness
of the merged firm after the combination. The less risky the combined firm is, the
greater the gains to the bondholders. The stockholders’ value lose by the
amount that bondholders’ gain especially when little or no synergy. Thus,
bondholders gain the co-insurance effect whereas the stockholders lose
the co-insurance effect. 

(3 x 1 mark = 3 marks)

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ii. Suggest two (2) strategies to be employed by stockholders to reduce the losses
from “co-insurance effect”.

a. Retire all existing debt at low pre-merger price and reissue an equal
amount of debt after the merger.  Because debt is retired at the low pre-
merger price, the type of refinancing transaction can neutralize the “co-
insurance effect” to the bondholders.

b. Issue more debt after merger.  Since the debt capacity of the merged
firm is likely to increase, thus it will have two effects:
 interest tax shield from new debt raises firm’s value
 increase in debt after merger raises the probability of financial distress;
hence reduce bondholders’ gain from the “co-insurance effect”

(2 x 1 mark = 2 marks)

(Total: 20 marks)

QUESTION 5

A.
i. Three types of market participants in the foreign exchange market:

i. Importers who pay for goods using foreign currencies. 

ii. Exporters who receive foreign currency and may want to convert to the domestic
currency. 
iii. Portfolio managers who buy or sell foreign shares and bonds. 
iv. Foreign exchange brokers who match buy and sell orders. 
v. Traders who “make a market” in foreign currencies. 
vi. Speculators who try to profit from changes in exchange rates. 

(Any 3 x 1 mark = 3 marks)

ii. Two (2) elements of risks faced by an international firms:

i. Exchange rate risk is the natural consequence of international operations in a

world where relative currency values move up and down. 
The sub-exchange rate risk consists of the following:
 Short-Term Exposure (Transaction Exposure or Risk) 
 Long-Term Exposure (Economic Exposure or Risk) 
 Translation Exposure

ii. Political risk is the changes in value that arise as a consequence of political
actions which affects both locally and internationally. 

(Any 2  x 1 marks = 2 marks)

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B.
i. If Abraham has £1,500 with him. The rate of the hotel at booking time is $240
per night of stay per room. The exchange rate is £1.00 = $1.60.
In dollars, this is £1,500 / £1.00 x $1.60 = $2,400.

$2,400 / $240 = 10 nights. 

ii. Abraham stayed for 5 days  x $240 = $1,200.

The exchange rate changes to £1 = $1.20.

The amount of money left in pound from £1,500 brought by him earlier would
be:

$2,400 - $1,200 = $1,200. 

$1,200 / $1.20 x £1 = £1,000. 

iii. When the exchange rate fluctuates in dollar from $1.60 to $1.20, means
the dollar is appreciates or stronger  whilst the pound is depreciates
or weaken  because now, £1 can only buy $1.20 whereas before £1
could buy $1.60. So, when Abraham convert from dollar to pound he is
able to earn profit on difference in currency by £250 (£1,000-£750 **)

**Note: $1,200 / $1.60 x £1 = £750

(10 x ½ marks = 5 marks)

C(i). In a semi-strong form efficiency, the underlying rationale for the efficient market
hypothesis is the presence of information that is available to all investors, which
includes information from technical analysis (past info) and in corporate press
release (public info).  It implies that the securities will be fairly or correctly price,
given all information that is available to investors in a semi strong form
efficiency.

As the shares of Apple are moving downward trend which lost 11.7% in last month
shown by the chart plus the announcement made in corporate letter by the Apple CEO
on the revenue shortfall from $89-$93 billion to $84 billion, has resulted the share price
further down by another 6% since the end of December. The reaction of stock price
plunged instantaneously in responded to the bad information released indicates
that the market is efficient in the semi-strong form efficiency.  Thus, consistent
with other analysts who have cut their price targets on Apple over the last month, the
prediction of the new share price would be drop but only in the short-term. The profit
opportunities should be a normal profit  only as the investors have no time to trade
on it to beat the stock market.

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(Any 3  x 1 mark = 3 marks)

C(ii). It is suggests the investors buy the Apple shares  as the stock price has brought the
valuation down to a cheap level and it’s believed that it would drop temporarily. Further,
the management has confidence that Apple is still one of the most valuable brands in the
world and trusted brand by its customer, it possibly make the stock price rebound
again and worth considering right now and in the future in view of company’s
long-term growth potential. 
(2 x 1 mark = 2 marks)
D.
i. The timing of decision

If financial markets are efficient, securities are always correctly priced.  Efficiency
implies that stock is sold for its true worth, so the timing decision becomes
unimportant. 

ii. Speculation

If financial markets are efficient, managers should not waste their time trying to
forecast the movement of interest rates and foreign currencies to make borrowing.
Their forecast will likely be no better than chance as the price of the borrowing will
always be at correctly priced.
(5 x 1 mark = 5 marks)
( Total: 20 marks)

END OF SOLUTION

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