QUESTION

Corporate Finance

Assignment

 

 

Learning Outcomes

The assignment requires you to apply the theory and/or model of corporate finance that you learn in lecture to solvethe given problem.

 

The assignment requires you to:

• Explain risk in relation to return on investment
• Identify an investor’s risk profile
• Apply risk management strategies
• Apply financial mathematics
• Critically analyse the relationship between risk, risk profile, and the required return on investment, and provide recommendations to the given problem

 

Value of the Assignment

The assignment is worth 20% of the total marks for this course

 

Format of the Assignment

1. Word limit of 2000 applies. You are required to be precise in your response.
2. The report is to be printed on white sheets of A4 size paper, single sided, double spaced with the Arial font type (size 12).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Question

John, who turns 30 today (1 March 2012), commences his new employment with the University of Newcastle on 1 March 2012. His remuneration package includes a salary of $75,000 and an employer superannuation contribution of 17%. John is required to make an additional contribution between 4% and 7% from his own salary.

 

On the offer of employment letter, he is informed that the superannuation contribution will be made to the industry-based fund Unisuper Ltd*. The contribution will be made into a Defined Benefit Division (DBD) with the option of transferring to an Accumulation 2(A2) plan within the initial 12 months of membership or employment.

 

However, in recent weeks, news about the financial health of Unisuper have become headlines in the local news bulletin.

• Retirement Income at risk for Unisuper members

(go to http://www.abc.net.au/7.30/content/2011/s3392159.htm)

• Superfund put workers’ entitlement at risk

(go to http://www.abc.net.au/7.30/content/2011/s3390328.htm)

 

John also read a recent media release by Unisuper Ltd on these issues. The media release is available at http://www.unisuper.com.au/about-us/news?articleid=39C0CA8D-0CF6-D57F-A83F581E6D681CA0

 

John wants to determine which of the two plans (DBD and A2) would suit him best. You meet John and find the following about him**.

 

John plans to retire when he turns 65. He is single and intends to remain single for the rest of his life. He plans to remain with the University until retirement. For his retirement, John plans to have a modest lifestyle, free of any debt obligation. He plans to have an income of $40,000 per annum for his first year of retirement with an annual indexation according to inflation rate. John has $20,000 in his superannuation fund from his previous employment and intends to rollover the $20,000 into Unisuper Ltd. John also informs you that the salary of $75,000 is indexed at 2% per half-yearly. Adjustment to the income takes place on 1 March and 1 October every year. John also has a savings account with a total of $15,000. This saving comes from his salary and John saves 5% of his pay.

 

 

Ignore taxation.

 

Required:

Considering the current financial market and given the publicly available data from Unisuper Ltd., explain to John investment under the DBD and A2 plans and make your recommendation to John.

 

Your explanation and recommendation must consider the recent headlines on Unisuper Ltd. and discussed using the following financial concepts:

1. time value of money;
2. risk profile;             and
3. risk and return.

 

__________________________________________________________

 

* The website for Unisuper Ltd is www.unisuper.com.au. John is not permitted to choose his own superannuation fund. All information on Unisuper is available on the website.

** In your analysis, you may make further assumptions on John and/or the economic conditions. Please provide a rationale for the chosen assumption. .

Marking Guide

 

 

 

Grading Guide

 

	Marks
Excellent	26- 30	Response is effective and shows sound knowledge of the financial theory and concepts. Goes beyond the given criteria.
Satisfactory	20 – 24	Response is satisfactory and shows good knowledge of the financial theory and concepts. Meets all the criteria.
Average	15 – 19	Response is adequate and sufficiently meet all the criteria or meet some (more than 50 percent) but not all the criteria
Poor	10 – 14	Response is poor and meets 50 percent or less of the criteria and demonstrates weak knowledge of the theory and concepts
Non-existent	1 – 9	Response does not address the question, meets less than 50 percent the objectives and demonstrates weak or no knowledge of the theory and concepts.
Penalty	0	The work is plagiarised or there is no submission of assignment

 

 

Relevant periodicals and websites

 

The following reading materials and websites are useful as point of reference:

 

Periodicals and Newspaper

Business Review Weekly

Australian Financial Review

 

Websites

Reserve Bank of Australia (www.rba.gov.au)

Australian Stock Exchange (www.asx.com.au)

Australian Federal Treasury (www.treasury.gov.au)

Australian Bureau of Statistic (www.abs.gov.au)

 SOLUTION

Risk & Types of Risk

Risk associated with an investment is the uncertainty associated with an investment for the return that the investment is expected to give. However the investment may or may not give the desired or expected return (Penman, 2007).

 

The risk associated with an investment increases with the expected return from that investment. It thus becomes essential for investor to establish the balance between what is desired how much the risk taking capability is there.

 

The risk can be categorized as two type:

1. Stand Alone Risk

It is the risk that is associated with a single investment portfolio or investment option. For example for Unisuper the various asset class include cash, fixed deposit, property etc.

The effect of standalone risks can be reduced by making investments in different asset class. This is to say is to diversify the risk. Stand alone risk is the sum of the market risk and the firm specific risk.

S(r) = M(r) + F(r)

Where,

M(r) is the Market risk. It is that part of the stand-alone risk of an investment that cannot be eliminated by diversifying the portfolio.

F(r) is the Firm risk. It is that part of the stand alone risk that can be reduced if not eliminated completely by diversifying the risk of the investment. It is also called Business or Operating Risk. It is the risk associated with the day to day working of the firm. Business risk is associated with the earnings before interest and tax.

1. Portfolio risk

The portfolio risk is the risk associated with the investment in a particular portfolio with the return of the different assets that form the part of the portfolio. Thus portfolio risk is the risk of all the assets of the portfolio.

There are sources of risks that govern the two types of risks discussed above, These are

Inflation: The risk associated with the increase in inflation has the impact on the risk of the portfolio. The risk increases as the inflation rises and decrease with the decrease in inflation rate.(Brearley and Mayers 2002)

Interest Rate: A major source of risk of the holders of high quality bonds is changes in interest rates. The prices of high quality bonds are determined by the prevailing interest rates and are not subjected to business or financial risk. The investor

Management & Purchasing Power: Whenever investors desire to preserve their economic poition over time, they utilize investment outlets whose values vary with the price level. They select investment whose market value change with consumer prices.

Financial risk: It is the risk associated with the chance of loss and the variability of the owners return created by the source of fund of the firm. Financial risk is concerned with earnings available to equity holders. Thus the financial risk reflect the chance that the firm might fail because of the inability of the firm to meet the interest and thus the payment of debt and the variability of the earnings to equity holders.

Others: There are risks associated with the change in regulatory framework, foreign exchange risks, change in government, nationalization of business etc.

Relation between Risk and Return

 

Below diagram shows the relationship between risk and return for the various asset class of Unisuper

 

 

 

 

High

 

Shares

 

Alternative

Investment

Potential return                                                                        Property

 

Fixed Deposit

Cash

 

Low

Low                                  Risk                                        High

 

 

As shown above the risk associated with cash and Fixed Deposit is on the lower side while the returns are also low where as the risk associated with the shares is more and thus the returns associated are also on the higher side.

 

Thus the relationship between risk and return is that the with the increase in risk the return associated with an asset increase.

 

Thus it can be seen from Unisuper that the two investment options are:

 

1. Defined Benefit Division

Under this plan the most of the benefit for the members is calculate using the formula that has been developed. The formula that has been developed for benefits calculation is

 

Benefit Salary X Period of Service X Lump Sum Factor X Average Service Fraction X Average Contribution Factor

The contribution under Defined Benefit Division will be defined benefit component and Accumulation component

 

Defined Benefit Component will have 14% employer contribution and standard member contribution

 

Accumulation component will have 3% employer contribution (if any) and the voluntary contribution by the member.

 

The critics see the Defined Benefit Division associated with lower risk due to two things. Firstly the impact of market fluctuation is reduced. Secondly the return are based on standard formula thus the benefits estimation will be easier.

 

The only disadvantage of the Defined Benefit Division is that one cannot choose how the investment will be made.

 

1. Accumulation 2

The Accumulation 2 members can manage their own accounts as they have the option of choosing their own investments. There are a lot of options like cash, shares, fixed deposits etc.

 

In this benefits on the investment ins not calculated by the formula but by the performance of the investment option that has been chosen.

 

Thus the benefits are subjected to more risks and the returns have to be calculated at a certain instance based on the investment performance.

 

The contribution to Accumulation 2 is made by the employer contribution which is upto 17% and the standard member contribution along with the investment returns and the fees and costs associated such as insurance premium.

 

Thus the Defined benefit division will have less return as the associated risk is less whereas the risk in making investments in Accumulation 2 is more thus will have more returns.

 

Risk Profiles

 

The risk taking ability of an individual defines the risk profile of an individual. The individual is categorized under different segments based on the risk taking ability of the investor based on which suitable investment opportunities are suggested. The various segments under the risk profile are conservative, moderate or aggressive segment (Jorion, 2006).

Below is the summarized detail of Johns Financial strength and his requirements

 

 

Annual Salary: $75,000

Years of service left: 35 years

Employer superannuation contribution: 17%.

Additional contribution by Employee: Between 4% and 7% from his own salary.

Superannuation fund: $20,000

Inflation Rate: 2%

 

Annual Salary on retirement: $40,000

 

Based on the indexing of salary of John on half Yearly basis the average salary for the 3 years of service is calculated after the indexing the salary by 2% on half yearly basis. This is done based on the assumption that the investment changes can be made based on the PDS. Thus we get the average salary as $160,690. And thus the average saving for above amount as calculated on 5% is $8034. It can be seen that John is having the risk profile of a moderate investor wherein he wishes to have annual salary on retirement and thus not show much returns except 2% indexing on annual basis after that. Thus John may go in for Defined Benefit Division due to following reasons

• The returns or benefit contribution will be based on the formula so the adjustments can be made by John so as to accurately estimate the annual retirement age.
• There is option of accumulation component in DBD wherein John can decide upon the investment to be made in different asset classes so as to earn 2% returns more.
• The tenure of service is long thus the Defined Benefit Division will provide more contribution.

This will reduce the risk for John and will ensure that the savings be made as per his requirement and invest more by increasing his component in DBD.

 

Risk Management

 

Risk management is the complete process of identification of risks, doing the proper assessment of it and to prioritize it to reduce the risk associated with the investment. It is also done to reduce the impact of the risk a particular investment (Allen 2003).

Risk management requires application of resources in order to minimize the risk and also to monitor the risk and return on a particular investment. This also assist is estimating the impact of unforeseen events and the opportunities created in the market

The strategy for risk management may vary based on the risk management method. The strategy may be of different types. These are:

Avoid Risk: Avoid the risk by taking suitable steps so that it does not exists in the changed scenario

Transfer Risk: Taking steps to transfer risk on another party or another aspect where it can be handled more easily or will have less impact

Reduce Risk or reduce probability of Risk: Taking prudent steps to reduce the risk and thus minimize its effect.

Accept Risk and Plan: Another way is to accept the risk associated and to plan accordingly taking the risk into consideration.

 

The impact of risk on a particular investment is based on the risk profile of the investor. Thus the steps for risk management are taken accordingly by the investor based on the profile.

 

For example as discussed above the risk profiles can be conservative, moderate or aggressive.

 

Thus the investor in conservative segment will look for steps to avoid risk whereas an aggressive investor will accept the risk and plan accordingly. Thus the risk management technique will differ based on the risk profile.

 

For the purpose to estimate the risk associated and the risk profile of the investor risk profile matrix can be developed which is representation of probability of the risk and the impact of risk. Based on this matrix the investors can make suitable decisions which suit their risk profile. Thus the investment with high probability and high impact may be considered by aggressive investor whereas the investment decisions lying closer to origin will have less risk and less probability thus this will be suitable for conservative investor.

 

Financial Analysis

 

The risk and return analysis can be done by Capital Asset Pricing Model which gives the relation between Risk Free Return and the Risk Premium. This is shown below;

 

E (Ri) = E(Rf ) +[E(Rm ) −E(Rf )]β

Where

E (Ri) is the net return on the investment

E(Rf ) is the risk free retrn

E(Rm ) −E(Rf ) is the risk premium

In relation to Defined Benefit Division and Accumulation 2 it can be said that Defined Benefit Division has more weight of risk free returns whereas Accumulation 2 has higher risk premium associated with it.

 

 Relation between Risk, Risk Profile and the required rate of return

The relation between risk, risk profile and the required rate of return can be give as that the risk profiles are governed by the risk associated with the investments. Thus the risk on an investment is governed by various factors such as interest rate, inflation, business risk etc. This risk and the risk taking capability of an investor define the risk profile of the investor. Thus the risk profile is directly associated with the risk associated with an investment. The other factor defining the risk profile is the required rate of return. Thus the required rate of return and risk together define the risk profile of the investor.

As per the information provided the risk profile of John may be termed as moderate type. Based on the indexing of salary of John on half Yearly basis the average salary for the 3 years of service is calculated after the indexing the salary by 2% on half yearly basis. Based on the analysis and discussion above it can be said that John may go in for Defined Benefit Division as the returns or benefit contribution will be based on the formula so the adjustments can be made by John so as to accurately estimate the annual retirement age. Also there is option of accumulation component in DBD wherein John can decide upon the investment to be made in different asset classes so as to earn 2% returns more. The tenure of service is long thus the Defined Benefit Division will provide more contribution.This will reduce the risk for John and will ensure that the savings be made as per his requirement and invest more by increasing his component in DBD.

References

• Brealey, R.A. and Myers, S.C., (2002), Corporate Finance: Financing And Risk Management, Tata Mcgraw Hill Education Private Limited
• Crouhy M Galai D. & Mark R, (2000), Risk management
• Allen S L, (2003), Financial Risk Management
• Jorion P, (2006), Value at Risk
• Penman, S., (2007), Financial Statement Analysis And Security Valuation, Tata Mcgraw Hill Education Private Limited
• UniSuper, (2011), Defined Benefit Division and Accumulation Super: How do they work in Practice
• UniSuper, (2011), Contribution Flexibility

KB03

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