Explain the relevance of the geometric average annual rate of return for an investor in the security.

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March 10, 2020

Explain the relevance of the geometric average annual rate of return for an investor in the security.

ACG 23 BUSINESS FINANCE: ASSIGNMENT PART B INFORMATION General Assignment Details Completion – Individual Basis This assignment must be completed and submitted on an individual basis. The assignment answers need to be prepared using Microsoft Word and must be submitted via Learnonline. You need to include your name and University of South Australia student ID number in your assignment document. Do not include the assignment questions in your assignment submission. Other Assignment Details Show all your working in the assignment calculations. In questions involving the use of a financial calculator, you are required to show all financial calculator steps in your answer. If you answer a question using a financial calculator, you do not need to detail the equivalent mathematical formula. Please refer to the Unit Outline for other details in relation to this assignment task. Question 1 (Total marks for this question = 10 marks) Consider a security whose value, at the end of each year, is given in the following table: Year Value of the Security 0 $100.00 1 $102.50 2 $103.72 3 $101.34 4 $102.81 5 $103.95 Note that the year 0 value of the security is the initial value. (a) Calculate the annual holding period returns for the security. (5 marks) (b) Calculate the arithmetic average annual rate of return and the geometric average annual rate of return for the security. (3 marks) (c) Explain the relevance of the geometric average annual rate of return for an investor in the security. (2 marks) Question 2 (Total marks for this question = 12 marks) Consider a corporate bond with a par value of $1,000 that will mature in 10 years. The market’s yield to maturity (YTM) on comparable-risk bonds is 5% per annum. (a) Calculate the coupon interest payments and the price of the bond if the coupon interest rate is 7% per annum, paid annually. (3 marks) (b) Calculate the coupon interest payments and the price of the bond if the coupon interest rate is 7% per annum, paid half-yearly. (3 marks) (c) Explain why the answers to parts (a) and (b) must be more than the par value of the bond. (2 marks) (d) Explain in general why there is an inverse relationship between the price and yield to maturity for bonds. (4 marks) Question 3 (Total marks for this question = 14 marks) A company has a capital structure consisting of bonds with a market value of approximately $1,083,000, preference shares with a market value of $268,000 and ordinary shares with a market value of $3,681,000. The bonds have a $100 par value and annual coupon interest payments at a rate of 10% per annum. The market value of each bond is $115 and the bonds have 10 years to maturity. The preference shares pay a dividend of $0.27 per share and the current market price of a preference share is $2 per share. The ordinary shares pay a current dividend of $0.12 per share and dividends are expected to grow at 5% per annum. The current market price of an ordinary share is $1 per share. Assume a company tax rate of 30%. (a) Determine the after tax costs of capital for the bonds, preference shares and ordinary shares. (8 marks) (b) Calculate the company’s after tax weighted average cost of capital. (4 marks) (c) Explain why the weighted average cost of capital could be used as the discount rate in capital budgeting projects where multiple financing sources are used. (2 marks) Question 4 (Total marks for this question = 14 marks) Consider an Australian owned company listed on the Australian Securities Exchange. Due to capital rationing, suppose the company is required to choose one of two investment projects: project A or project B. Project A is of 3 years length and has net cash flows before tax, in years 1-3 respectively, as follows: $100,000, $200,000, $150,000. Project B is of 4 years length and has net cash flows before tax, in years 1-4 respectively, as follows: $100,000, $50,000, $150,000, $200,000. The initial outlay for each project is $250,000. Assume a discount rate of 8% per annum for each project. Capital budgeting for the company is performed on a before tax basis. (a) Calculate the net present value (NPV) for project A and project B. Should the project with the higher NPV be chosen? Explain your answer. (6 marks) (b) Calculate the equivalent annual cost (EAC) for project A and project B. The equivalent annual cost (EAC) is also called the equivalent annual annuity (EAA). Which investment project would the company choose? Explain your answer. (6 marks) (c) Explain what is meant by capital rationing in capital budgeting. (2 marks) Total Marks for Assignment Part B = 50 Marks

ACG 23 BUSINESS FINANCE: ASSIGNMENT PART B INFORMATION
General Assignment Details
Completion – Individual Basis
This assignment must be completed and submitted on an individual basis. The assignment answers need to be prepared using Microsoft Word and must be submitted via Learnonline. You need to include your name and University of South Australia student ID number in your assignment document. Do not include the assignment questions in your assignment submission.
Other Assignment Details
Show all your working in the assignment calculations. In questions involving the use of a financial calculator, you are required to show all financial calculator steps in your answer. If you answer a question using a financial calculator, you do not need to detail the equivalent mathematical formula. Please refer to the Unit Outline for other details in relation to this assignment task.
Question 1 (Total marks for this question = 10 marks)
Consider a security whose value, at the end of each year, is given in the following table:
Year
Value of the Security
0
$100.00
1
$102.50
2
$103.72
3
$101.34
4
$102.81
5
$103.95
Note that the year 0 value of the security is the initial value.
(a) Calculate the annual holding period returns for the security. (5 marks)
(b) Calculate the arithmetic average annual rate of return and the geometric average annual rate of return for the security. (3 marks)
(c) Explain the relevance of the geometric average annual rate of return for an investor in the security. (2 marks)
Question 2 (Total marks for this question = 12 marks)
Consider a corporate bond with a par value of $1,000 that will mature in 10 years. The market’s yield to maturity (YTM) on comparable-risk bonds is 5% per annum.
(a) Calculate the coupon interest payments and the price of the bond if the coupon interest rate is 7% per annum, paid annually. (3 marks)
(b) Calculate the coupon interest payments and the price of the bond if the coupon interest rate is 7% per annum, paid half-yearly. (3 marks)
(c) Explain why the answers to parts (a) and (b) must be more than the par value of the bond. (2 marks)
(d) Explain in general why there is an inverse relationship between the price and yield to maturity for bonds. (4 marks)
Question 3 (Total marks for this question = 14 marks)
A company has a capital structure consisting of bonds with a market value of approximately $1,083,000, preference shares with a market value of $268,000 and ordinary shares with a market value of $3,681,000. The bonds have a $100 par value and annual coupon interest payments at a rate of 10% per annum. The market value of each bond is $115 and the bonds have 10 years to maturity. The preference shares pay a dividend of $0.27 per share and the current market price of a preference share is $2 per share. The ordinary shares pay a current dividend of $0.12 per share and dividends are expected to grow at 5% per annum. The current market price of an ordinary share is $1 per share. Assume a company tax rate of 30%.
(a) Determine the after tax costs of capital for the bonds, preference shares and ordinary shares. (8 marks)
(b) Calculate the company’s after tax weighted average cost of capital. (4 marks)
(c) Explain why the weighted average cost of capital could be used as the discount rate in capital budgeting projects where multiple financing sources are used. (2 marks)
Question 4 (Total marks for this question = 14 marks)
Consider an Australian owned company listed on the Australian Securities Exchange. Due to capital rationing, suppose the company is required to choose one of two investment projects: project A or project B. Project A is of 3 years length and has net cash flows before tax, in years 1-3 respectively, as follows: $100,000, $200,000, $150,000. Project B is of 4 years length and has net cash flows before tax, in years 1-4 respectively, as follows: $100,000, $50,000, $150,000, $200,000. The initial outlay for each project is $250,000. Assume a discount rate of 8% per annum for each project. Capital budgeting for the company is performed on a before tax basis.
(a) Calculate the net present value (NPV) for project A and project B. Should the project with the higher NPV be chosen? Explain your answer. (6 marks)
(b) Calculate the equivalent annual cost (EAC) for project A and project B. The equivalent annual cost (EAC) is also called the equivalent annual annuity (EAA). Which investment project would the company choose? Explain your answer. (6 marks)
(c) Explain what is meant by capital rationing in capital budgeting. (2 marks)
Total Marks for Assignment Part B = 50 Marks


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