Brief: Previously you provided advice to a client who had little knowledge of finance. As a result of your advice on financial theory and investment options, the client has again contacted you for further advice on additional aspects of finance, though this time at a much higher level of financial literacy. Again, it will be your responsibility to provide the mathematical calculations for the investment(s) they select and the theoretical questions they pose. Background: Your client, whom you are writing the report for, is a pathologist by profession. She has two children - aged 5 and 3, with a steady income. Her knowledge of financial theory and financial mathematics is now at an intermediate level. She (and her partner) is in a position to invest into sound investments for both short-term and long-term returns. She has done some research and has found a number of investments that she wishes to have analysed. As such, you do not have to search for viable investments for her. You also note that she wishes to invest into securities for retirement, with only the viability of the investment being considered in this report. While we can garner a degree of information to the clients financial position, we still do not know her (and her partners) financial position. In the same manner as the previous report you presented to them, it is impossible to know how many of these investments they can purchase / invest. Therefore you are expected to provide advice on each investment in isolation from the other investments, i.e. not as a portfolio of investments. Requirements: The report should contain the following information: • Introduction (100 words) Comprising a discussion on the purpose and context of the report. • Discussion / Workings Consisting of a discussion regarding your client’s financial questions and full workings regarding your client’s investment suggestions. • Conclusion (100 words) Summarising the discussion and possible investments and providing guidance and recommendations to the queries provided by your client. • References The presentation of the report should be using a report style (see the ‘Report Information’ link within the Assessment section of the BANK 2007 learnonline website) which follows the formatting requirements stated on the first page of the assignment (above). 3 | P a g e Clients Financial Questions: (25 marks) • Your client considered investing in either debt securities or equity securities and would like to know what are the main characteristics that distinguish the return on debt securities from the return and on equity securities? (12 marks) • Why does the yield change through time but the coupon rate does not? (4 marks) • The total risk of an individual share comprises both systematic and unsystematic risk. Explain both of these risk components and describe how each is affected by increasing the number of shares in a portfolio. (5 marks) • Your client is unsure why are investors focused on market risk only when applying the Capital Asset Pricing Model (CAPM) to price risky securities? (4 marks) 4 | P a g e Clients Investments: (40 marks) 1. Douwe Ltd. is a logistics company with the following balance sheet: Long-term debt $ Bonds: Par $100, annual coupon 7% p.a., 3 years to maturity 3,000,000 Equity Preference shares 1,000,000 Ordinary shares 6,000,000 Total 10,000,000 Notes: The company’s bank has advised that the interest rate on any new debt finance provided for the projects would be 8.5% p.a. if the debt issue is of similar risk and of the same time to maturity and coupon rate. There are currently 500,000 preference shares on issue, which pay a dividend of $0.17 per year. The preference shares currently sell for $2.50. The company’s existing 6,000,000 ordinary shares currently sell for $0.95 each and management has disclosed that it expects to pay a dividend of 5 cents per share at the end of the next year. Historically, dividends have increased at an annual rate of 7% p.a. and are expected to continue to do so in the future. The company’s tax rate is 30%. Your client wishes to understand, with the use of workings, the following aspects of this company and states that their required rate of return for the investment in a company with similar characteristics to Douwe would be 12% p.a. Advise the client on whether you believe this to be a good or bad investment and the rationale for investment (or not investing). a) What are the assumptions underlying the use of a dividend growth model for the estimation of a company’s cost of equity? b) Determine the market value proportions of debt, preference shares and ordinary equity comprising the company’s capital structure. c) Calculate the after-tax costs of capital for each source of finance. d) Determine the after-tax weighted average cost of capital for the company. 5 | P a g e e) Under what conditions can the firm’s weighted average cost of capital be used for assessing new projects? f) Provide recommendation to your client. (14 marks) 2. Your client is evaluating two mutually exclusive projects, X and Y. The cost of capital is 12%, and expected cash flows of the two projects are as follows: Year 0 1 2 3 4 5 Project X -$1,200 250 290 460 470 510 Project Y -$1,200 320 500 450 270 260 What is the payback period of the better project? (8 marks) 3. A firm that your client would like to invest is only accepts projects providing an IRR more than 15%. The company is evaluating an eight-year project that requires $74,515 in initial investment and provides $15,000 in annual net cash inflows. (a) What is the IRR of the project? Is it acceptable? (b) Assuming the annual net cash inflows continue to be $15,000, how many additional years would the flows continue in order to make the project acceptable (that is, to have an IRR of 15%)? (c) With the given project life (8 years) and initial investment, what is the minimum annual net cash inflows in order to make the project acceptable? (8 marks) 4. Your client is considering investing in one of the two Treasury bonds which have a face value of $100,000 and pay coupons at the rate of 10% semi-annually. Bond P has four years to maturity and bond Q has eight years to maturity. Your client would like to know: (a) If the current interest rate is 7.5% p.a., what are the prices of the two bonds? (b) If the interest rate rises to 12% p.a., what are the prices of the two bonds? (c) What are the observations can be made based on these results? (10 marks)