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FM – May 2016 – L3 – Q7 – Financing Decisions and Capital Markets

Comparing the cost of financing equipment replacement through an outright purchase funded by a loan versus a finance lease.

Question

MK Plc is considering the best way to finance the replacement for a particular high specification piece of equipment that has become too costly to maintain. The replacement equipment is estimated to have a useful life of 4 years with no residual value after that time.

Two alternative financing schemes are being evaluated:

Scheme A: Buy the equipment outright funded by a bank loan
Scheme B: Enter into a four-year finance lease

Scheme A: Buy outright, funded by a bank loan
MK Plc could purchase the equipment outright at a cost of N200 million on July 1, 2016. MK Plc can normally borrow at an annual interest rate of 13% per year.

Scheme B: Four-year finance lease
The equipment would be delivered on July 1, 2016, and MK Plc would pay a fixed amount of N58,790,000 each year in advance, starting on July 1, 2016, for four years. At the end of four years, ownership of the equipment will pass to MK Plc without further payment.

Other Information:

MK Plc has a cost of equity of 20% and WACC of 16%
MK Plc is liable to company tax at a marginal rate of 30%, which is settled at the end of the year in which it arises
Tax depreciation allowances on the full capital cost are available in equal instalments over the first four years of operation

You are required to:

a.

Calculate which payment method is expected to be cheaper for MK Plc and recommend which should be chosen solely on the present value of the two alternatives as at July 1, 2016. (13 Marks)

b.

Discuss the appropriateness of the discount rate used in (a). (2 Marks)

Answer

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Tags: Discount rate, Equipment Financing, Financing, Lease, Loan, Present Value
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – May 2023 – L3 – Q3 – Investment Appraisal Techniques

Evaluate Tinco Limited's expansion project using financial metrics, assess sensitivity to contribution and tax rate changes, and incorporate capital allowances.

Question

Tinco Limited (TL) is considering an expansion project. The project will involve the acquisition of an automated production machine costing ₦11,000,000 and payable now. The machine is expected to have a disposal value at the end of 5 years, which is equal to 10% of the initial expenditure.

The following schedule reflects a recent market survey regarding the estimated annual sales revenue from the expansion project over the project’s five-year life:

Level of Demand	₦’000	Probability
High	16,000	0.25
Medium	12,000	0.50
Low	8,000	0.25

It is expected that the contribution to sales ratio will be 50%. Additional expenditure on fixed overheads is expected to be ₦1,800,000 per annum. TL incurs a 20% tax rate on corporate profits. Corporate tax is paid one year in arrears.

TL’s after-tax nominal (money) discount rate is 15.5% per annum. A uniform inflation rate of 5% per annum will apply to all costs and revenues during the life of the project. All of the values above have been expressed in terms of current prices.

You can assume that all cash flows occur at the end of each year and that the initial investment does not qualify for capital allowances.

Required:

a.
i. Evaluate the proposed expansion from a financial perspective. (10 Marks)
ii. Calculate and interpret the sensitivity of the project to changes in:

The expected annual contribution (3 Marks)
The tax rate (2 Marks)

b.
You have now been advised that the capital cost of the expansion will qualify for written down allowances at the rate of 25% per annum on a reducing balance basis. Also, at the end of the project’s life, a balancing charge or allowance will arise equal to the difference between the scrap proceeds and the tax written down value.

You are required to calculate the financial impact of these allowances. (5 Marks)

Answer

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Tags: Capital Budgeting, Discount rate, NPV, Sensitivity Analysis, Tax Allowances
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

Question

The following draft appraisal of a proposed investment project has been prepared for the Finance Director of Keke Plc (KP) by a trainee accountant. The project is consistent with the current business operations of KP.

Year	1	2	3	4	5
Sales (units/yr)	250,000	400,000	500,000	250,000
Contribution (₦000)	13,300	21,280	26,600	13,300	–
Fixed costs (₦000)	(5,300)	(5,618)	(5,955)	(6,312)	–
Depreciation (₦000)	(4,375)	(4,375)	(4,375)	(4,375)	–
Interest payments (₦000)	(2,000)	(2,000)	(2,000)	(2,000)	–
Taxable profit (₦000)	1,625	9,287	14,270	613
Taxation (₦000)	–	(488)	(2,786)	(4,281)	(184)
Profit after tax (₦000)	1,625	8,799	11,484	(3,668)	(184)
Scrap value (₦000)	–	–	–	2,500	–
After-tax cash flows (₦000)	1,625	8,799	11,484	(1,168)	(184)
Discount at 10%	0.909	0.826	0.751	0.683	0.621
Present values (₦000)	1,477	7,268	8,624	(798)	(114)

Net present value = (16,457,000 – 20,000,000) = ₦3,543,000, so reject the project.

Additional Information:

The initial investment is ₦20 million.
Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by annual charges to the project.
Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
Keke Plc can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation one year in arrears at a rate of 30% per year.
The scrap value of machinery at the end of the four-year project is ₦2,500,000.
The real weighted average cost of capital of Keke is 7% per year.
The general rate of inflation is expected to be 4.7% per year.

Required:

a. Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(4 Marks)

b. Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability.
(12 Marks)

c. Discuss the problems faced when undertaking investment appraisal in the following areas and comment on how these problems can be overcome:
i. An investment project has several internal rates of return;
ii. The business risk of an investment project is significantly different from the business risk of current operations.
(4 Marks)

(Total: 20 Marks)

Answer

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Tags: Business risk, Depreciation, Discount rate, Fixed Costs, Inflation, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Investment Appraisal Techniques
Series: MAY 2024

FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques

Calculate and compare NPV for two proposals involving equipment purchase vs. existing machinery for contract fulfillment.

Question

Niko Plc, a large equity-financed company, has a year-end of December 31. It must fulfill a contract in Abuja and has two proposals to choose from: Proposal A (purchasing new machinery) and Proposal B (using existing machinery).

Proposal A:

Outlay of N312,500,000 on December 31, 2023, for new plant and machinery.
Projected net cash inflows (before tax, in nominal terms):
- 2024: N200,000,000
- 2025: N275,000,000
- 2026: N350,000,000
Scrap value: N25,000,000 at end of 2026.

Proposal B:

Uses a machine with a net realizable value of N250 million, with an alternative sale value of N300 million on January 1, 2025, if unused.
Cash inflows (in nominal terms):
- 2024: N350,000,000
- 2025: N350,000,000
Labour costs:
- 2024: N100 million (replacement staff cost of N110 million)
- 2025: N108 million (replacement staff cost of N118.8 million)
Machine residual value: N0 at project end in 2025.

Additional Details:

Working capital: 10% of year-end cash inflows, released upon project completion.
Expected annual inflation rates: 2024 – 10%, 2025 – 8%, 2026 – 6%, 2027 – 5%.
Real cost of capital: 10%.
Income tax: 40%, payable one year after the accounting period.
Capital allowances: 20% reducing balance for Proposal A’s plant and machinery.

Required:

a. Calculate the NPV at December 31, 2023, for each proposal. (17 Marks)
b. State any reservations about making an investment decision based on these NPV figures. (3 Marks)

Answer:

Answer

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Tags: Capital Allowance, Cash Flow, Discount rate, Investment Appraisal, NPV, Project evaluation
Level: Level 3

Topic: Investment Appraisal Techniques
Series: NOV 2023

AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers

Calculating the valuation per share for minority and complete takeover of Fasco and Boscan, and discussing limitations of the approach.

Question

Zed Ltd is considering the immediate purchase of some, or all, of the share capital of one of two firms—Fasco Ltd and Boscan Ltd. Both Fasco Ltd and Boscan Ltd have one million ordinary shares issued, and neither company has any debt capital outstanding.

Both firms are expected to pay a dividend in one year’s time—Fasco’s expected dividend amounting to 30p per share, and Boscan’s being 27p per share. Dividends will be paid annually and are expected to increase over time. Fasco’s dividends are expected to display perpetual growth at a compound rate of 6% per annum. Boscan’s dividend will grow at the high annual compound rate of 33⅓% until a dividend of 64p per share is reached in year 4. Thereafter, Boscan’s dividend will remain constant.

If Zed is able to purchase all the equity capital of either firm, then the reduced competition would enable Zed to save some advertising and administrative costs, which would amount to GH¢225,000 per annum indefinitely, and, in year 2, to sell some office space for GH¢800,000. These benefits and savings will only occur if a complete takeover is carried out. Zed would change some operations of any company completely taken over, the details are:

Fasco – No dividend would be paid until year 3. Year 3 dividend would be 25p per share, and dividends would then grow at 10% per annum indefinitely.
Boscan – No change in total dividends in years 1 to 4, but after year 4, dividend growth would be 25% per annum compound until year 7. Thereafter, annual dividends would remain constant at the year 7 amount per share.

An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.

Required:
a) Calculate the valuation per share for a minority investment in each of the firms, Fasco and Boscan, which would provide the investor with a 15% rate of return. (6 marks)

b) Calculate the maximum amount per share which Zed should consider paying for each company in the event of a complete takeover. (8 marks)

c) Comment on any limitation of the approach used in part (a), and specify the other major factors which would be important to consider if the proposed valuations were being undertaken as a practical exercise. (6 marks)

Answer

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Tags: Acquisition, Discount rate, Dividend Growth, Synergies, Valuation
Level: Level 3

Topic: Valuation of acquisitions and mergers
Series: NOV 2017

CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets

The question requires the accounting treatment for the impairment of development costs in line with IAS 36 for Alabar Ltd, with cash flow projections and a discount rate.

Question

The trial balance of Alabar Ltd extracted from the company’s general ledger as at 31 December 2017 showed a development costs balance of GH¢12.8 million. The development costs consist of amounts capitalized in 2015 and 2016 relating to a new product development. No additional development expenditure was incurred in the year ended 31 December 2017. The product began commercial production on 1 July 2017, and the company estimated at that date that, the product’s useful life was four years due to its technological nature.

Sales of the product did not achieve the amount expected during the second half of 2017, and so, at 31 December 2017, management performed an impairment test on the development expenditure. The estimated net cash flows are (at 31 December 2017 prices):

Year to 31 December 2018: GH¢3.2 million
Year to 31 December 2019: GH¢3.4 million
Year to 31 December 2020: GH¢1.6 million
6 months to 30 June 2021: GH¢0.8 million

All cash flows occur on the final day of each period mentioned. An appropriate annual discount rate (adjusted to exclude the effects of inflation) is 5%. The fair value of the development expenditure asset was expected to be less than the sum of the discounted cash flows.

The company recognizes amortization and impairment losses on development expenditure in cost of sales.

Required:
Set out the accounting treatment as the above information permits in the financial statements of Alabar Ltd for the year 31 December 2017. (6 marks)

Answer

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Tags: Cash Flow, Development Costs, Discount rate, Impairment, Intangible Assets
Level: Level 3

Topic: IAS 38: Intangible assets
Series: MAY 2019

CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Advice on the depreciation adjustment and decommissioning cost for a plant in the books of Odehyieba Plc, including financial statement impacts.

Question

entity has decided to reduce the remaining useful life of the plant by 5 years. For the current year ended 30 April 2023, no entry has been made for depreciation on the plant, neither has there been any adjustments to decommissioning cost.

Item	Amount (GH¢)
Carrying value of the plant	6,000,000
Remaining useful life	11 years
Revaluation surplus	960,000
Provision for decommissioning	1,600,000

There is no change in the expected decommissioning cost except for the timing due to the change in useful life. The applicable discount rate is 11% per annum. Odehyieba Plc has a policy of transferring revaluation surplus to retained earnings only upon disposal.

Required:
Advise on the appropriate financial reporting treatment for the above in the books of Odehyieba Plc in the 2023 financial statements for the year ended 30 April 2023. (6 marks)

Answer

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Tags: Contingent Liabilities and Contingent Assets, Decommissioning Costs, Depreciation, Discount rate, Financial Reporting, Revaluation Surplus
Level: Level 3

Topic: IAS 37: Provisions, Contingent Liabilities and Contingent Assets
Series: NOV 2023

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

Question

The directors of Fameko Ltd (Fameko), a courier delivery services company based in Ghana, are considering a proposal for setting up a subsidiary in the United States of America to provide courier services in North America. The capital of this new subsidiary will be structured as 20% equity and 80% debt.

The directors are not sure of what would be an appropriate discount rate for appraising the North American business. You have been asked to recommend an appropriate discount rate for this project. You have gathered the following information for this exercise.

Competition in the U.S. Courier industry:
The U.S. courier services industry is highly competitive. If Fameko sets up in the U.S., its main competitor will be ExFed Corporation. ExFed’s capital structure is 70% equity and 30% debt.
Market risk:
The following statistics have been computed from historical excess returns on the equity stock of ExFed Corporation and that on the S&P 500 Index (a proxy for the market portfolio):

	S&P 500 Index	ExFed Equity Stock
Average return	0.0628	0.0321
Standard Deviation	0.1875	0.1521
Sample Variance	0.0352	0.0231
Kurtosis	-1.4335	-1.1121
Skewness	-0.2178	-0.1601

You analyzed the correlation between the excess returns on ExFed and excess returns on the S&P 500 Index and obtained a correlation coefficient of 0.91.

The annual risk-free rate and market return:
The annual rate of interest on the 10-year U.S. Treasury bond is 2.1%. The expected return on the S&P 500 Index is 7%.
Taxation:
ExFed pays corporate income tax at the rate of 30%. However, the effective corporate income tax rate on profits from Fameko’s North American operations will be 35%.

Required:

i) Compute the equity beta of ExFed. (3 marks)

ii) Derive an appropriate equity beta for Fameko’s U.S. subsidiary. (4 marks)

iii) Using the capital asset pricing model or the Modigliani and Miller Proposition II with tax, compute an appropriate cost of equity for Fameko’s U.S. subsidiary. (3 marks)

Answer

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Tags: Beta calculation, CAPM, Cost of Equity, Discount rate, Risk Management
Level: Level 2

Topic: Cost of capital, Portfolio theory and the capital asset pricing model (CAPM)
Series: NOV 2020

FM – May 2016 – L3 – Q7 – Financing Decisions and Capital Markets

Comparing the cost of financing equipment replacement through an outright purchase funded by a loan versus a finance lease.

Question

Two alternative financing schemes are being evaluated:

Scheme A: Buy the equipment outright funded by a bank loan
Scheme B: Enter into a four-year finance lease

Other Information:

MK Plc has a cost of equity of 20% and WACC of 16%
MK Plc is liable to company tax at a marginal rate of 30%, which is settled at the end of the year in which it arises
Tax depreciation allowances on the full capital cost are available in equal instalments over the first four years of operation

You are required to:

a.

Calculate which payment method is expected to be cheaper for MK Plc and recommend which should be chosen solely on the present value of the two alternatives as at July 1, 2016. (13 Marks)

b.

Discuss the appropriateness of the discount rate used in (a). (2 Marks)

Answer

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Tags: Discount rate, Equipment Financing, Financing, Lease, Loan, Present Value
Level: Level 3

Topic: Financing Decisions and Capital Markets

FM – May 2023 – L3 – Q3 – Investment Appraisal Techniques

Evaluate Tinco Limited's expansion project using financial metrics, assess sensitivity to contribution and tax rate changes, and incorporate capital allowances.

Question

The following schedule reflects a recent market survey regarding the estimated annual sales revenue from the expansion project over the project’s five-year life:

Level of Demand	₦’000	Probability
High	16,000	0.25
Medium	12,000	0.50
Low	8,000	0.25

You can assume that all cash flows occur at the end of each year and that the initial investment does not qualify for capital allowances.

Required:

a.
i. Evaluate the proposed expansion from a financial perspective. (10 Marks)
ii. Calculate and interpret the sensitivity of the project to changes in:

The expected annual contribution (3 Marks)
The tax rate (2 Marks)

You are required to calculate the financial impact of these allowances. (5 Marks)

Answer

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Tags: Capital Budgeting, Discount rate, NPV, Sensitivity Analysis, Tax Allowances
Level: Level 3

Topic: Investment Appraisal Techniques

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

Question

Year	1	2	3	4	5
Sales (units/yr)	250,000	400,000	500,000	250,000
Contribution (₦000)	13,300	21,280	26,600	13,300	–
Fixed costs (₦000)	(5,300)	(5,618)	(5,955)	(6,312)	–
Depreciation (₦000)	(4,375)	(4,375)	(4,375)	(4,375)	–
Interest payments (₦000)	(2,000)	(2,000)	(2,000)	(2,000)	–
Taxable profit (₦000)	1,625	9,287	14,270	613
Taxation (₦000)	–	(488)	(2,786)	(4,281)	(184)
Profit after tax (₦000)	1,625	8,799	11,484	(3,668)	(184)
Scrap value (₦000)	–	–	–	2,500	–
After-tax cash flows (₦000)	1,625	8,799	11,484	(1,168)	(184)
Discount at 10%	0.909	0.826	0.751	0.683	0.621
Present values (₦000)	1,477	7,268	8,624	(798)	(114)

Net present value = (16,457,000 – 20,000,000) = ₦3,543,000, so reject the project.

Additional Information:

The initial investment is ₦20 million.
Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by annual charges to the project.
Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
Keke Plc can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation one year in arrears at a rate of 30% per year.
The scrap value of machinery at the end of the four-year project is ₦2,500,000.
The real weighted average cost of capital of Keke is 7% per year.
The general rate of inflation is expected to be 4.7% per year.

Required:

a. Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(4 Marks)

b. Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability.
(12 Marks)

(Total: 20 Marks)

Answer

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Tags: Business risk, Depreciation, Discount rate, Fixed Costs, Inflation, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Investment Appraisal Techniques
Series: MAY 2024

FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques

Calculate and compare NPV for two proposals involving equipment purchase vs. existing machinery for contract fulfillment.

Question

Proposal A:

Outlay of N312,500,000 on December 31, 2023, for new plant and machinery.
Projected net cash inflows (before tax, in nominal terms):
- 2024: N200,000,000
- 2025: N275,000,000
- 2026: N350,000,000
Scrap value: N25,000,000 at end of 2026.

Proposal B:

Uses a machine with a net realizable value of N250 million, with an alternative sale value of N300 million on January 1, 2025, if unused.
Cash inflows (in nominal terms):
- 2024: N350,000,000
- 2025: N350,000,000
Labour costs:
- 2024: N100 million (replacement staff cost of N110 million)
- 2025: N108 million (replacement staff cost of N118.8 million)
Machine residual value: N0 at project end in 2025.

Additional Details:

Working capital: 10% of year-end cash inflows, released upon project completion.
Expected annual inflation rates: 2024 – 10%, 2025 – 8%, 2026 – 6%, 2027 – 5%.
Real cost of capital: 10%.
Income tax: 40%, payable one year after the accounting period.
Capital allowances: 20% reducing balance for Proposal A’s plant and machinery.

Required:

a. Calculate the NPV at December 31, 2023, for each proposal. (17 Marks)
b. State any reservations about making an investment decision based on these NPV figures. (3 Marks)

Answer:

Answer

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Tags: Capital Allowance, Cash Flow, Discount rate, Investment Appraisal, NPV, Project evaluation
Level: Level 3

Topic: Investment Appraisal Techniques
Series: NOV 2023

AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers

Calculating the valuation per share for minority and complete takeover of Fasco and Boscan, and discussing limitations of the approach.

Question

Fasco – No dividend would be paid until year 3. Year 3 dividend would be 25p per share, and dividends would then grow at 10% per annum indefinitely.
Boscan – No change in total dividends in years 1 to 4, but after year 4, dividend growth would be 25% per annum compound until year 7. Thereafter, annual dividends would remain constant at the year 7 amount per share.

An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.

Required:
a) Calculate the valuation per share for a minority investment in each of the firms, Fasco and Boscan, which would provide the investor with a 15% rate of return. (6 marks)

b) Calculate the maximum amount per share which Zed should consider paying for each company in the event of a complete takeover. (8 marks)

Answer

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Tags: Acquisition, Discount rate, Dividend Growth, Synergies, Valuation
Level: Level 3

Topic: Valuation of acquisitions and mergers
Series: NOV 2017

CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets

The question requires the accounting treatment for the impairment of development costs in line with IAS 36 for Alabar Ltd, with cash flow projections and a discount rate.

Question

Year to 31 December 2018: GH¢3.2 million
Year to 31 December 2019: GH¢3.4 million
Year to 31 December 2020: GH¢1.6 million
6 months to 30 June 2021: GH¢0.8 million

The company recognizes amortization and impairment losses on development expenditure in cost of sales.

Required:
Set out the accounting treatment as the above information permits in the financial statements of Alabar Ltd for the year 31 December 2017. (6 marks)

Answer

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Tags: Cash Flow, Development Costs, Discount rate, Impairment, Intangible Assets
Level: Level 3

Topic: IAS 38: Intangible assets
Series: MAY 2019

CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Advice on the depreciation adjustment and decommissioning cost for a plant in the books of Odehyieba Plc, including financial statement impacts.

Question

Item	Amount (GH¢)
Carrying value of the plant	6,000,000
Remaining useful life	11 years
Revaluation surplus	960,000
Provision for decommissioning	1,600,000

Required:
Advise on the appropriate financial reporting treatment for the above in the books of Odehyieba Plc in the 2023 financial statements for the year ended 30 April 2023. (6 marks)

Answer

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Tags: Contingent Liabilities and Contingent Assets, Decommissioning Costs, Depreciation, Discount rate, Financial Reporting, Revaluation Surplus
Level: Level 3

Topic: IAS 37: Provisions, Contingent Liabilities and Contingent Assets
Series: NOV 2023

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

Question

Competition in the U.S. Courier industry:
The U.S. courier services industry is highly competitive. If Fameko sets up in the U.S., its main competitor will be ExFed Corporation. ExFed’s capital structure is 70% equity and 30% debt.
Market risk:
The following statistics have been computed from historical excess returns on the equity stock of ExFed Corporation and that on the S&P 500 Index (a proxy for the market portfolio):

	S&P 500 Index	ExFed Equity Stock
Average return	0.0628	0.0321
Standard Deviation	0.1875	0.1521
Sample Variance	0.0352	0.0231
Kurtosis	-1.4335	-1.1121
Skewness	-0.2178	-0.1601

You analyzed the correlation between the excess returns on ExFed and excess returns on the S&P 500 Index and obtained a correlation coefficient of 0.91.

The annual risk-free rate and market return:
The annual rate of interest on the 10-year U.S. Treasury bond is 2.1%. The expected return on the S&P 500 Index is 7%.
Taxation:
ExFed pays corporate income tax at the rate of 30%. However, the effective corporate income tax rate on profits from Fameko’s North American operations will be 35%.

Required:

i) Compute the equity beta of ExFed. (3 marks)

ii) Derive an appropriate equity beta for Fameko’s U.S. subsidiary. (4 marks)

iii) Using the capital asset pricing model or the Modigliani and Miller Proposition II with tax, compute an appropriate cost of equity for Fameko’s U.S. subsidiary. (3 marks)

Answer

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Tags: Beta calculation, CAPM, Cost of Equity, Discount rate, Risk Management
Level: Level 2

Topic: Cost of capital, Portfolio theory and the capital asset pricing model (CAPM)
Series: NOV 2020

Question Tag: Discount rate

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FM – May 2016 – L3 – Q7 – Financing Decisions and Capital Markets

Comparing the cost of financing equipment replacement through an outright purchase funded by a loan versus a finance lease.

a.

b.

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FM – May 2023 – L3 – Q3 – Investment Appraisal Techniques

Evaluate Tinco Limited's expansion project using financial metrics, assess sensitivity to contribution and tax rate changes, and incorporate capital allowances.

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FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

You're reporting an error for "FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques"

FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques

Calculate and compare NPV for two proposals involving equipment purchase vs. existing machinery for contract fulfillment.

You're reporting an error for "FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques"

AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers

Calculating the valuation per share for minority and complete takeover of Fasco and Boscan, and discussing limitations of the approach.

You're reporting an error for "AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers"

CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets

The question requires the accounting treatment for the impairment of development costs in line with IAS 36 for Alabar Ltd, with cash flow projections and a discount rate.

You're reporting an error for "CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets"

CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Advice on the depreciation adjustment and decommissioning cost for a plant in the books of Odehyieba Plc, including financial statement impacts.

You're reporting an error for "CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets"

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

You're reporting an error for "FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)"

FM – May 2016 – L3 – Q7 – Financing Decisions and Capital Markets

Comparing the cost of financing equipment replacement through an outright purchase funded by a loan versus a finance lease.

a.

b.

You're reporting an error for "FM – May 2016 – L3 – Q7 – Financing Decisions and Capital Markets"

FM – May 2023 – L3 – Q3 – Investment Appraisal Techniques

Evaluate Tinco Limited's expansion project using financial metrics, assess sensitivity to contribution and tax rate changes, and incorporate capital allowances.

You're reporting an error for "FM – May 2023 – L3 – Q3 – Investment Appraisal Techniques"

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

You're reporting an error for "FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques"

FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques

Calculate and compare NPV for two proposals involving equipment purchase vs. existing machinery for contract fulfillment.

You're reporting an error for "FM – Nov 2023 – L3 – SB – Q3 – Investment Appraisal Techniques"

AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers

Calculating the valuation per share for minority and complete takeover of Fasco and Boscan, and discussing limitations of the approach.

You're reporting an error for "AFM – Nov 2017 – L3 – Q3 – Valuation of acquisitions and mergers"

CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets

The question requires the accounting treatment for the impairment of development costs in line with IAS 36 for Alabar Ltd, with cash flow projections and a discount rate.

You're reporting an error for "CR – May 2019 – L3 – Q2b – IAS 38: Intangible assets"

CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Advice on the depreciation adjustment and decommissioning cost for a plant in the books of Odehyieba Plc, including financial statement impacts.

You're reporting an error for "CR – Nov 2023 – L3 – Q2b – IAS 37: Provisions, Contingent Liabilities and Contingent Assets"

FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)

Calculate the appropriate discount rate for a new subsidiary in the U.S. using CAPM and Modigliani-Miller Proposition II.

You're reporting an error for "FM – Nov 2020 – L2 – Q1b – Cost of capital | Portfolio theory and the capital asset pricing model (CAPM)"

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