MGT201 Financial Management Assignment 2 Solution Spring 2013

PROBLEM # 1: (15 Marks)

Ms. Nabila invests the following amounts of money in common stocks having expected returns as follows:

Company

Amount Invested

(Rs.)

Expected

Return

Silver Marketing

172,000

0.18

Sumi Incorporation

165,000

0.15

Star Leather Manufacturers

196,000

0.20

Alpha Bank Limited

150,000

0.13

Newland Foods

180,000

0.16

Standard Cement

200,000

0.17

Required:

(a) Calculate the expected return on Ms. Nabila’s portfolio? ( 7 Marks )

(b) What would be the expected return on portfolio if she doubles her investment in Alpha Bank Limited while keeping everything else the same? ( 7 Marks )

(c) What impact this increase of investment in Alpha Bank Limited would have on the expected return of portfolio? Justify your answer with logical reasoning. ( 1 Mark )

Q#1 (Part a) Ans = 16.6267%

Part b = Ans = 18.00%

 

PROBLEM # 2: (15 Marks)

Standard Corporation has recently been formed to manufacture leather bags. It has the following components in its capital structure.

(Rs.)

Common Stock

12,000,000

Preferred Stock

4,000,000

Debentures (Debt)

8,000,000

The firm has just paid the dividend of Rs. 2 per share and there is an expected annual growth rate of 10 percent in dividends. The firms’ stock has been priced at Rs. 32 per share. Standard Corporation is currently yielding 12 percent on its debt and its cost of preferred stock is 11 percent. The company has a marginal tax rate of 35 percent.

Required:

(a) Compute the cost of equity for Standard Corporation. ( 5 Marks )
Cost Of Equity

Re = D1/Po + g

 

2(a). Cost of Equity = 16.88%     

(b) Compute the firm’s weighted average cost of capital (WACC). ( 8 Marks )

Formula

WACC-Weighted Average Cost of Capital

Formula

The following is the WACC calculation formula:

WACC = E/V × Re + D/V × Rd × (1 – Tc)
where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D = firm value
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

WACC = E/V × Re + D/V × Rd × (1 – Tc)
E/vxRe+P/vxRp+D/VxRdx (1-tax rate)
E=12m 12 E/V = 0.5
V=24m=12m+4m+8m 24 P/V = 0.166667
Re=16.88% 0.1688 D/V = 0.333333
P=4m 4
Rp=11% 0.11 1- TaxRate = 65%
D= 8m 8
Rd=12% 12%
Tax rate is 35% 35%
Putting the Values in Formula
0.128733 or 12.87%

 

(c) Based on the result computed in part (b), should the firm undertake a project having 11 percent rate of return? Support your answer with conceptual rationale. ( 2 Marks )

 

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