MAF 302 Trimester 2, 2012

Assessment weight: 25%

Submission Due Date: Printed Copy: Monday 5 pm September 10, 2012 D2L Copy: Monday 5 pm September 10, 2012

Instructions Please read carefully This assignment is to be attempted by a group of 3-4 students. Students do not necessarily have to be in the same tutorial class, BUT MUST BE FROM THE SAME CAMPUS. The last date to form your group 15 August, 2012. The group formation option on DSO will be shut down after this date. Under special circumstances students will be allowed to attempt this assignment individually. However, students will need to obtain prior permission from the unit coordinator of your campus/cohort and no special consideration will be given to any single effort in marking the assignment. This assignment has 3 questions, you can assign of member for each problem to take lead and initiate the solution. It is important that group members contact each other regularly and update about their progress. The assignment will be marked for the group as a whole, however if any group faces any problem among the members, they should come and see their Lecturer. The Lecturer may then decide the level of individual contribution and mark for each student in the group. All the members of the group are expected to individually attempt and then discuss all the questions with the group. Allocation of questions to members at the very beginning (i.e., before attempting individually and before any discussion has been taken place) is strongly discouraged. Only after a full discussion of all the questions and possible answers/solutions, should the members of the group divide the workload among themselves. The unit guide states that the word limit for the assignment is 3000-3500 words but we are not too concerned if you cannot reach that limit. Word limit is very insignificant in this unit. An electronic copy of the assignment (only one copy per group) has to be uploaded to D2L by 5pm 10 September 2012. If you experience any problem in uploading the

document, please contact the D2L help line on 1800 721 720 or go to the website at: http://www.deakin.edu.au/its/servicedesk/. Dont call your Lecturer. A hard copy (i.e., printed copy) of the assignment (only one copy per group) must also be submitted by 5pm 10 September 2012 to the designated venues (Assignment submission boxes in Faculty of Business & Law office in each campus). Please note: The uploaded soft copy to D2L will be considered the official copy and the time of upload to D2L will determine if the assignment was submitted on time. Late assignments will be penalized at a rate of 2 marks per calendar day late. For example if your assignment scores 18 out of 20 but is 4 days late, the final result would be 18 - (2 x 4) = 10 out of 20. Both the electronic copy and the hard copy must be identical and should be prefaced by one assignment cover sheet that contains the names and student ID numbers of all group members. All group members should have signed the assignment cover sheet of the hard copy of the assignment. It is extremely important for you to note that only students whose names appear on the front page of the assignment will receive assignment mark. If Excel is used in the assignment, the Excel spreadsheet/results will have to be integrated into the main assignment. Separate Excel spreadsheets will not be marked. Contact a staff member if you have any further queries regarding the assignment.

Read the above instructions, before approaching the assignment problems

Question 1 You are expecting to graduate and start a full time job in January 2014. In an effort to secure your retirement life, you have made a plan to save some money from your monthly salary during your working life and accumulate it in a bank account that pays 15% interest compounding annually. You expect to live for another 20 years after you retire. After retirement you plan to shift the entire accumulated amount to a new bank, which agrees to pay you 18% interest compounding annually. You have estimated that your accumulated savings would be enough to fulfil your need to spend $3,500 at the beginning of each quarter during your retired life of 20 years. You are expecting to retire in December 2044 and you want to start spending $3,500 from the first quarter of 2045. How much do you need to save each month during your service period to be able to spend $3,500 per quarter during your retirement life? [5 Marks]

Question 2 Elgar Pharmaceutical Ltd is a very small size company which is considering a major capital expenditure of $400,000 to expand its business for the first time. There are two possible scenarios that the expansion path may take: Scenario-1: The Pharmaceutical Company would run at full capacity; at the end of year one the total business would be worth $700, 000. Scenario-2: There is a 30% probability that the company would face tough competition from new competitors in the market; the demand for its pharmaceutical product would drop and the business would be worth only $340, 000 after one year. The company has decided to borrow its $400, 000 capital from a Melbourne bank at a 15% interest rate. (i). (ii). Calculate the NPV of the project and make a decision of whether to invest. The Elgar Ltd management do not expect the outcome of the project to be better than the normal expectation (as described by scenario 1 and 2 above), but they are concerned that the project may face additional adverse situations. Therefore, they have asked you to conduct a sensitivity analysis for the NPV in the Pessimistic condition, as described by the variables below:

Variables/items Interest rate Initial investment Probability of failure Business worth (Full capacity) Business worth (tough competition) (iii).

Normal 15% $400, 000 30% $700, 000 $340, 000

Pessimistic 20% $500, 000 50% $600, 000 $240, 000

You have been asked to advise the company about its investment decision. Explain your advice. [10 Marks]

Questions 3 Burwood Mining is raising capital of $500,000 sources: Sources Common stock Preferred stock Bank loan Debenture Retained Earnings Total for its next project from the following Amount $ 100,000 50,000 150,000 100,000 100,000 500,000

The annual return on the Treasury securities is 11%; the market index indicates that the average return on the market is 18%. The company has issued its debt instruments promising to pay interest of 15% p.a.. The company has also secured a bank loan at 14%. The Burwood companys equity beta has recently gone up to 1.4; such increase is due to the introduction of Carbon Tax. The company is subject to a tax rate of 35%. The company management has also decided to pay the holders of preferred stock 300 basis points less return than their common stock holders. Scenario 1- The proposed new project is expected to bring an annual after tax cash flow of $100,000 forever. The project however faces a 20% probability of getting $70,000 annually, after paying tax, in perpetuity. Scenario 2- Everything in the scenario 1 is the same except that if it is a failure the business would be worth only $300,000 as a scrap value at the end of the first year. You however are unsure of the probability of success and failure in this scenario. NB: Please ignore the word as a scrap value; the line should be read as- the business would be worth only $300,000 at the end of the first year. Burwood Mining Ltd is also aware that a large competitor has expressed an interest in acquiring the project at the end of the first year for $400,000 regardless of the outcome of the expansion. The sale price would include any cash flows accrued during the first year of trading.

(i) (ii).

Calculate the NPV of the project in scenario 1 Applying one of the option pricing models that you have learnt, value the abandonment option available to Burwood Mining Ltd in the form of a possible sale of the business to the large competitor company. Use the NPV that you obtained in Scenario 1 as the current value of Mining project.

[10 marks]