Finance: 1477419

Question 1

1. Systematic risk refers to the risk that exists on account of market factors i.e. factors that impact the market as a whole. One example of systematic risk would be the slowing down of economic growth since its impact would prevail across the market rather than being limited to a specific industry or company. Unsystematic risk refers to the risk which arises on account of factors that impact the performance of a particular industry or firm. For instance, the risk of increasing raw material price for a given industry (Brealey, Myers & Allen, 2014).

• I) Covid 19 pandemic poses a systematic risk since the impact of this event is not limited to Qantas or the airline industry but across all the industries to differing extent.

ii) The introduction of harsh carbon emission rules would be an unsystematic risk since this event would not necessarily impact all sectors of the economy and the impact would be limited to industries emitting carbon emissions.

iii) The rise in fuel cost is a systematic risk ince oil is directly or indirectly used by every industry. As a result, rising fuel cost would lead to rising inflation and hence would impact the economy as a whole.

iv) The reduction of cash lending rates of RBA would lead to lower interest rates. This would be a systematic risk since the impact of this step would not be limited to only Qantas or airline industry but would be applicable for all the industries and economy as a whole.

v) The major strike by pilots poses unsystematic risk since this would impact Qantas and potentially the airline industry. However, the other industries and sectors would remain unimpacted by this strike.

• Buying price of share = $30

Selling price of share = $35

Let the dividend paid be $X per share

The returns derived from holding the share is 10%

Hence, 0.1= (35+X-30)/30

0.1*30 = 5+X

Solving the above, we get X = -$2

• Price of AGL share last year = $25

Price of AGL share in the current year = $ X

Dividend paid over the last year = $1.5

Total return = 20%

Hence, 0.2 = (X+1.5-25)/25

0.2*25 = X -23.5

Solving the above, we get X = $28.5

Question 2

1. The principal message of CAPM approach is that the expected returns by investors on the asset or stock is driven by the systematic risk. Higher the systematic risk, higher would be the return expectations of the investors. The various assumptions of CAPM are as follows (Lasher, 2013).
2. The investors have rational expectations which are similar.
3. There are no taxes and transaction costs.
4. There is no information asymmetry between market participants.
5. Investors are risk averse.
6. Unlimited borrowing and lending can take place at risk free rate.

• Beta is a measure of systematic risk for a financial security. This is relative value computed with regards to the market index which has a default value of 1.  A company would prefer to have a lower beta as compared to a higher beta. This is because if the company would have a higher beta, then the expected returns demanded by investors would be higher. The result is that the cost of equity would be higher for a company with high beta. This would increase the WACC and the hurdle rate for acceptability of feasible projects (Petty et. al.,2014).

• A luxury cruise ship company would have a higher beta. This is because the luxury cruise travel is not a necessary service and would be highly sensitive to economic environment and income of the customers. Hence, the stocks of these companies tend to be more volatile. On the contrary, the fast food demand is more stable and less susceptible to changes in economic climate and customer income levels (Berk et. al., 2016). Hence, the stock prices also tend to be less volatile on either side. Thus, the beta would be higher for luxury cruise ship.

• Expected return on stock = Risk free rate + Beta*Market Risk Premium

Expected return on Brinkbank = 3% + 1.2*6% = 10.2% p.a.

As against the expected returns of 10.2% p.a. on Brinkbank shares, it delivered 15% returns. Hence, it can be concluded that the Brinkbank share is currently undervalued. The share value needs to increase to the extent when the actual return reduces from 15% to 10.2%. This would ensure that share is fairly priced (Brealey, Myers & Allen, 2014).

• Expected returns on the given share = 4% + 1.25*(10%-4%) = 11.5% p.a.

Current price of the share = $30

Expected price of the share after one year =$33

Expected dividend = $0

Hence, expected returns during next one year = (33-30)/30 = 10%

Since the returns in next one year (i.e. 10%) is lower than the desired return of 11.5% p.a. on the stock, hence I would not buy the share.

Question 3

1. Operating leverage may be defined as the extent to which the operating income of the company is impacted by the changes in sales. If the operating leverage of the company is high, it would imply that the operating income of business is highly sensitive to sales. Thus would imply that the various systematic risk factors such as changes in interest rate, changes in economic growth would have significant impact not only on the revenues but also the operating income (Lasher, 2013). This would indicate influence on the EPS and thereby the stock prices. Hence, for companies with high operating leverage, the stock prices is likely to be quite volatile. Owing to this the movements in the stock price would be significantly higher than the underlying index on either side. This would therefore indicate that the company’s equity beta is also high since it measures systematic risk (Petty et. al., 2014).

• Cost of equity for company P = 5% + 1.1*(12% -5%) = 12.7% p.a

Cost of equity for company Q = 5% + 1.45*(12%-5%) = 15.15% p.a.

Cost of debt for both company P and Q = 8% p.a.

Weight of debt for company P = 10%

Weight of equity for company P = 90%

Weight of debt for company Q = Weight of equity for company Q = 50%

1. WACC for company P = 0.1*8% + 0.9*12.7% = 12.23%

WACC for company B = 0.5*8% + 0.5*15.15% = 11.58%

1. Now taxes are to be considered, hence after tax cost would be considered. For equity, there is no difference between the pre-tax and post tax cost. However, for debt, the post tax cost for the two companies = 8%*(1-0.3) = 5.6%

WACC for company P = 0.1*5.6% + 0.9*12.7% = 11.99%

WACC for company Q = 0.5*5.6% + 0.5*15.15% = 10.38%

1. Company Q is benefitted more from the tax effect on the WACC. This is because it had a higher weightage of debt in its capital structure. As a result, the lowering of debt cost after considering tax lead to more decline in WACC of company Q then company P. For company P, the WACC declined from 12.23% to 11.99%(a drop of 24 bps) as compared to company Q for which WACC declined from 11.58% to 10.38% (a drop of 120 bps).

Question 4

1. Capital structure may be defined as the combination of debt and equity which would be used by the company to finance the business operations. It reflects the riskiness of the business since a very high amount of debt can potentially imply a greater degree of financial risk for the business. This is because unlike equity, debt needs to be repaid back. As a result, if the company assumes a very high proportion of debt, then this can lead to higher risk of default (Brealey, Myers & Allen, 2014).

• The use of long term debt is known as financial leverage since debt can be taken besides the invested equity capital in order to purchase assets for the business. Thus, debt allows the company to borrow and invest capital in the business driven by the underlying equity. Considering that equity capital has a higher cost, hence it is not advisable that the entire funding should be driven by equity capital. As a result, financial leverage is imperative whereby long term debt is taken so as to fund business operations (Berk et. al., 2016).

• As per the fundamental principle of financial leverage, if long term debt replaced equity in the capital structure of a company, then the expected returns for the shareholders (measured by ROE) and the expected risk both tend to increase. Financial leverage works positively when the underlying return on incremental investment through long term debt is higher than the underlying cost associated with that investment. Financial leverage works negatively when the underlying return on incremental investment through long term debt is lower than the underlying cost associated with that investment (Petty et. al., 2014).

• Considering the given capital structure of the company, WACC = (5/9)*15% + (4/9)*9% = 12.33%

The altered capital structure of the company after buy back would comprise of $30 million in equity and $60 million in debt. Since the proportion of debt has increased and that of equity has decreased, hence the WACC would be lower than 12.33%. This is because the cost of debt is significantly lower than the cost of equity.

With regards to the expected returns on equity or cost of equity, it would be greater than 15%. This is because there is higher financial leverage in the capital structure of the company which would indicate higher financial risk associated with the company. To compensate for this higher financial risk, the equity investors would demand a higher return (Brealey, Myers & Allen, 2014).

References

Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2016). Fundamentals of corporate finance. London: Pearson Higher Education

Brealey, R. A., Myers, S. C., & Allen, F. (2014). Principles of corporate finance (2nd ed.). New York: McGraw-Hill Inc.

Lasher, W. R., (2013) Practical Financial Management (5^thed.). London: South- Western College Publisher.

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2014). Financial Management, Principles and Applications (6^thed.).  NSW: Pearson Education, French Forest Australia.