Question

State two features regarding debt and equity instruments that result in equity instruments having a higher cost of capital

The Australian Treasury is issuing 10-year bonds that have a face value of $100 paying half-yearly coupons at 4% p.a. The bonds mature at par. Spencer purchases the bonds at the issue date that are priced at a yield to maturity of 5.2% p.a. Calculate the size of each coupon payment giving your answer correct to the nearest cent.

The Australian Treasury is issuing 10-year bonds that have a face value of $100 paying half-yearly coupons at 4% p.a. The bonds mature at par. Spencer purchases the bonds that are priced at a yield to maturity of 5.2% p.a. Calculate the bond price Spencer paid, giving your answer correct to the nearest 0.1 cent.

The Australian Treasury is issuing 10-year bonds that have a face value of $100 paying half-yearly coupons at 4% p.a. The bonds mature at par. Spencer purchases the bonds that are priced at a yield to maturity of 5.2% p.a. If Lisa buys the bond from Spencer in 2 years' time for $95.115, has the yield to maturity risen or fallen?

Everlast Corporation is expecting to pay $0.66 in dividends at the end of the year. The company pays half-yearly dividends and they do not expect the dividends to increase. Today the company's stock price is $11. Calculate the effective annual return on equity implied by the price, giving your answer as a % correct to 2 decimal places

Unsworth Investments is offering securities that will promise to pay investors a quarterly distribution of $0.10 and is expected to grow at 0.5% per quarter. The first distribution is in three months' time. Calculate the fair value of this security if the market prices it at 10% p.a. Give your answer correct to the nearest cent.

Explain two factors that may impact on the return on equity for a company.

A company can invest in building a factory that will cost $75m. The factory is expected to deliver $30m of net revenue for the first four years and then $40m in the next four years. The factory will be expected to have a salvage value of $3m and is depreciated using the straight line method. The risk-adjusted discount rate is 17% p.a.

a) What is the definition of the risk-adjusted discount rate in the context of this project? (0.5 marks)

b) Calculate the free cashflows for years 1 to 8 in millions of dollars.

c) Calculate the net present value in millions of dollars correct to 3 decimal places and interpret your answer. (1.5 marks)

d) Calculate the discounted payback period in years correct to two decimal places. (1 mark)

e) What will happen to the internal rate of return if the risk-adjusted discount rate of the project decreases to 15% p.a. and everything else is constant? (1 mark)

National Foods Limited reported a Net Profit After Tax of $50m for the year. Explain one factor that may determine how much dividends they will pay their shareholders for this year.

Answer 1

Equity has higher cost because

1. Equity Cashflows are residual in nature i.e. after everyone else is paid,the remaining is due to Equity shareholders. This results in higher risk to equity holders , so they demand a higher rate of return which translates to higher cost

2. There is no tax advantage in equity all the profit earned and left over is taxed and then distributed. No tax benefit also makes the cost of equity high

Size of each coupon payment= Face Value * annual Coupon rate / (no of payments in a year) = $100*4%/2 = $2

YTM per six months = 5.2%/2 = 2.6%= 0.026

So, Price P of the bond is given by

P = 2/1.026+ 2/1.026^2+...+2/1.026^20+100/1.026^20

=2/0.026* (1-1/1.026^20) + 100/1.026^20

= $90.73425

Semiannual YTM (y) of the bond after 2 years (16 coupon periods remaining) is given by

2/y*(1-1/(1+y)^16) + 100/(1+y)^16 = 95.115

Using hit and trial method , or using solver tool of Excel

y = 0.023704

So, annual YTM = 2*0.023704 = 0.047408 or 4.7408%

So, the YTM has fallen in the two years from 5.2% to 4.7408%