Analyse the determinants of the pricing of debt securities

Assignment Help Portfolio Management

Reference no: EM132366150

Learning outcomes (LO) mapping

1. Explain the concept of valuation and the purpose of valuing assets.
2. Construct a valuation based on the discounted cash flow valuation technique.
3. Explain capital market theoryand other pricing theories.
4. Analyse the determinants of the pricing of debt securities.
5. Analyse how hybrids provide flexibility for management.
6. Explain the basic principles in pricing futures and options.
7. Evaluate valuation techniques for real estate assets

Section A - Undertake a net present value analysis

Instructions to students

There are five (5) questions in this section. Answer allquestions.
You are required to build a DCF model from a template of Excel worksheets provided in KapLearn under ‘Assignment'.
DO NOT change the layout of the financial model in any way. Do not create new rows or columns.
Formulas must be used in your Excel spreadsheet to create the model. Hard entered or typed numbers will be penalised.
Within Excel, ensure you install the ‘Analysis ToolPak' and ‘Analysis ToolPak - VBA' under 'Tools - Add Ins'.
Submit the Excel answer template via KapLearn along with your Word answer template.

The suggested methodology for building the model is as follows:
• in the ‘Assumptions' worksheet, enter all the relevant financial information and discount rate assumptions in the blue shaded cells, and base calculations in the grey shaded cells
• the remaining worksheets contain yellow and grey shaded cells
• the yellow cells should be linked to other cells in the workbook
• the grey cells require a formula to be entered based on the other cells in the workbook.

Section A of the assignment requires you to undertake a Net Present Value analysis of a project.

Case study: Saratoga Lake Taxis

Saratoga Lake Taxis (SLT) is a water ferry service provider for transport on rivers, lakes and other small bodies of water. They have over 400 ferries and water taxis in operation in several major cities and key tourist locations. You currently work as the company's finance manager and are interested in replacing some older boats with new, autonomous water vehicles (AWVs). The solar-powered AWVs are able to decrease trip times by 20% and also reduce labour costs.

SLT is currently a profitable business with positive cash flow. Furthermore:
• the business is projected to turnover $42 million for the forthcoming financial year, representing approximately 10 million fares.
• revenues, which is a function of passenger numbers and ticket prices, have grown at the inflation rate of 3.0% p.a.
• the gross profit margin is typically 40%.

The details of the proposed upgrade are as follows:
• the purchase of six (6) new AWVs at a cost of $1,150,000 each, to be paid at the start of the project
• the new AWVs will service the 6 top routes, with existing ferries to be used to open upthree(3) new minor routes.
• the expected economic life of the AWVs is 10 years, which is also the life for taxation purposes. At such time the vehicles will be retired to a minor route or sold. The expected salvage value for the vehicles is $150,000 each, and depreciation on the AWVs will be calculated under the straight-line methodology
• the AWVs are expected to affect earnings as follows:
- reduce ferry operator wages by $130,000 per year (increasing with inflation)
- new AWV service costs of $70,000 per year per AWV plus $60,000 per year for upgrade to systems for the six AWVs
- reduce fuel costs by $90,000 per year
- increase annual passenger trip numbers on the new minor routes from 0 to 60,000 at an average fare price of $3.25 trip
- increase annual passenger trip numbers on the major routes from 2,900,000 (expected) to 3,000,000. The price of these trips will also increase from an expected level of $5.20 per trip to $5.40
- additional working capital of $150,000 required from the start of the project and which will be freed up in full at completion.

Question 1 Cash flows

LO2: Construct a valuation based on the discounted cash flow valuation technique.

Build the Cash Flow Model. Cells in blue are inputs, cells in yellow require links from other cells, and cells in grey require calculations.
(a) Complete the ‘Assumptions and Base Calculations [Assumptions]' worksheet of the Excel template using the data provided in the case study above.
(b) Complete the ‘Projected Net Profit [Projections]' worksheet using the data from the ‘Assumptions and Base Calculations‘worksheet completed in (a) above.

Note: The model should take into account all the incremental cash flows identified in the assumptions above, including the following elements:
• Revenue
• Expenses
• EBITDA
• EBIT
• Working capital
• Taxation
• Capital expenditure.

Question 2 Discount rate

LO2: Construct a valuation based on the discounted cash flow valuation technique.

LO3: Explain capital market theory and other pricing theories.

You are required to perform a DCF valuation on the project using a high and low weighted average cost of capital (WACC). Calculate the WACC in the ‘Discounted Rate Calculation [Discount Rate]' worksheet.

Note: Show all workings, state all assumptions and use formulas within Excel as required.
(a) Calculate the cost of ordinary equity for the company in the ‘Discount Rate' worksheet.
(b) Calculate the WACC for the company in the ‘Discount Rate' worksheet.

Question 3 Net present value

LO2: Construct a valuation based on the discounted cash flow valuation technique.

Calculate the project's net present value in the ‘Project Valuation' worksheet.

Note: Show all workings, state all assumptions and use formulas within Excel as required.
(a) Based on the WACC, calculate the present value factors for each year of the project of the project.
(b) Based on the cash flows in your model and the present value factors, calculate the NPV of the project.

Question 4 Sensitivity and scenario analysis

LO1: Explain the concept of valuation and the purpose of valuing assets.

LO2: Construct a valuation based on the discounted cash flow valuation technique.

Conduct a scenario analysis and sensitivity analysis of the project in the ‘Scenario Analysis' and ‘Sensitivity Analysis' worksheets respectively.

Note: Show all workings, state all assumptions and use formulas within Excel as required.

(a) The valuation conducted thus far is based on best estimates of future performance. This is known as the ‘base scenario'. A scenario analysis is conducted by creating alternative scenarios where variables have been given other reasonable values. Conduct a scenario analysis based on the following changes to the project variables:
• Worst case scenario
- creditors demand an extra margin of 1.1% p.a.
- incremental revenues are $1 million less than expected
(in Year 1, growing from there by inflation).
- salvage value is half of what is expected.
• Best case scenario
- debt margin falls by 0.4% p.a.
- incremental revenues are $200,000 more than expected, which leads to an increase in incremental costs of $20,000 (in Year 1, growing from there by inflation).
- salvage value is one-third more than expected.
- the corporate tax rate is cut to 25%.
(b) An important part of valuation analysis is undertaking sensitivity analysis, to see how sensitive the model is to changes in assumptions. Conduct a 10% sensitivity analysis of the NPV against the following three (3) variables:
• WACC
• incremental revenues
• salvage value.
Note: You are not required to provide your scenario or sensitivity analysis NPV calculations in the spreadsheet (but the resultant NPVs should be included in the relevant cells).

Question 5 Project evaluation (Word limit: 900 words)

LO1: Explain the concept of valuation and the purpose of valuing assets.

In answering this question refer to the valuation and analyses you completed in Questions 1 to 4 above.

(a) Based on the NPV calculated in Q3, provide a recommendation as to whether the company should pursue this project. Explain your answer.
(b) Analyse two (2) strengths and two (2) weaknesses of the financial model used.
(c) How would your answer in Part 5(a) above change if you had included the interest repayments in the DCF model? Explain why adding interest costs is not appropriate.
(d) The company has previously spent $1,000,000 on research and development regarding autonomous water vehicles and associated infrastructure. How should this affect the NPV calculation and decision on whether or not to proceed with the project?
(e) What are your conclusions regarding the scenario analysis and sensitivity analysis conducted in Q4? How might these analyses affect the recommendation regarding the project.

Section B - Equity pricing

Introduction

Section B of the assignment requires you to calculate Price/Earnings and Earnings before Interest and Tax (EBIT) multiples.

Question 1 Market based valuation methods (Word limit: 500 words)

LO1: Explain the concept of valuation and the purpose of valuing assets

LO3: Explain capital market theory and other pricing theories.

Wynbet, an ASX listed company, is a major provider of online sports gambling in Australia and North America. It provides a platform to connect various betting agencies to a global audience of professional and amateur betting enthusiasts.

Refer to the following summarised financial information for the past six years, presented from oldest (left) to most recent (right).

(a) Provide a comment on the trend in earnings and dividend per share from 20X0 to the present (20X5).

(b) The dividend payout ratio in 20X2 exceeded 100%. Explain how this is possible? In your answer, comment on why the management may have made this decision and what you think their view was on the outlook for WynBet at the time.

(i) Calculate the historical dividend yield for WynBet for each year from 20X0 to 20X5, as a % to 1 decimal place.

(ii) In one year's time (20X6), what is the forecast share price WynBet needs to reach in order to provide an appropriate risk adjusted return to its shareholders?

(iii) Assume you had undertaken a DCF analysis of WynBet and it determined the likely share price in one year's time was $23.50. Would this be a ‘buy',‘sell' or ‘hold' recommendation? Explain your answer.

Question 2 Market-based valuation methods (Word limit: 600 words)

LO1: Explain the concept of valuation and the purpose of valuing assets

LO3: Explain capital market theory and other pricing theories.
Assume the following valuation metrics for WynBet as at the present (20X5):
• adjusted shares outstanding of 79.6 million
• adjusted debt of $670 million
• depreciation and amortisation in 20X5 of $29.8 million
• forecast PE multiple of 27.0 for 20X6.

(a) Calculate WynBet's 20X5 PE multiple and EBIT multiple. Show all workings.

(b) Explain why the forecast PE multiple, when calculated on the same date (and therefore use the same share price) might be different to the trailing multiple calculated in part (a).

(c) Based on your share price derived from your DCF analysis of $23.50, calculate the implied PE multiple. What do your implied multiples suggest in relation to the forecast multiple?
Show all workings. Would this change your recommendation from Q1(c)(iii) above?

(d) In 20X4 a competitor of WynBet was independently valued in the range from $651 million to $726 million. The implied forecast PE and EBIT multiples based on this range were 15.3×-17.0× forecast NPAT, and 10.5×-11.7× forecast EBIT.

Assuming market and economic conditions are similar, provide two (2) other reasons why these multiples for the competitor might be different to those observed for WynBet.

Section C

Question 1 Understanding debt securities (Word limit: 300 words)

LO4: Analyse the determinants of the pricing of debt securities.

(a) The yield to maturity of a fixed rate security is a measure of expected return and can be used when comparing similar securities. Which of the following would be considered an equivalent metric for a floating rate security (choose one (1)):
• initial margin
• trading margin
• reference rate return to maturity.

Justify your response.

(b) The relationship between a security's coupon and yield (e.g. Is the coupon less than, greater than, or equal to, the yield?) directly affects the corresponding relationship between its capital and face values. Identify and name the three (3) possible relationships that can exist between capital and face values and explain how each relates to the relationship between coupon and yield.

Question 2 Analysing debt securities (Word limit: 100 words)
LO4: Analyse the determinants of the pricing of debt securities.
(a) As treasurer of a large Australian corporation you are always trying to park surplus cash in the money market (either overnight or for up to a 12 month term). You currently have surplus funds to be invested for a 12 month period. As a treasurer you have a relationship with a number of Australian commercial banks that quote you the following rates:
• Bank A 2.87% annually
• Bank B 2.83% monthly
• Bank C 2.85% quarterly.

Based on these rates alone, which bank would you recommend investing with?

Show all workings for each option.

(b) The next day, your company receives an additional $600,000 surplus funds.

The funds need to be invested for 90 days. Bank A states and offers the following:

‘We don't offer wholesale interest rates on funds invested less than $2 million. We do, however, offer 2.75% p.a. on a 90-day bank accepted bill or we can offer 2.80% p.a. simple discount over the same period.'

Compare the return on the two alternatives offered and calculate which is the more attractive investment option. Note: Assume that $600,000 is the FV. Show all workings for each option.

Question 3 Pricing debt securities (Word limit: 100 words)

LO4: Analyse the determinants of the pricing of debt securities.

(a) Calculate the value of a 4.50%, 15 March 2021 maturity Commonwealth Treasury bond with a yield to maturity of 3.96%. Assume a settlement date of 11 December 2018. In your answer show the values of each of the variables v, f, d, g, x,iand n. Show all workings.

(b) Assuming the value of the bond (in part a) is $101, explain two (2) reasons why the price might be higher than the face value of $100?

Question 4 Valuing hybrid securities (Word limit: 500 words)

LO5: Analyse how hybrids provide flexibility for management.

(a) Research a hybrid issued by an ASX listed company in the past six months and provide the following information (if applicable).

(b) Discuss the issues confronted when valuing convertible notes and the most common valuation methodologies used.

Attachment:- Fundamentals of Asset Valuation.rar

Reference no: EM132366150

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Reviews

len2366150

9/5/2019 2:08:33 AM

Excellent (Mark range: 4–5 marks) • good understanding of metrics used in analysing and comparing fixed interest securities • 2 correct relationships identified and fully described

9/5/2019 2:08:23 AM

Excellent (Mark range: 8–10 marks) • correct calculations • correct explanation of multiples • clear reasoning and explanation of difference in multiples

9/5/2019 2:08:13 AM

Excellent (Mark range: 8–10 marks) • correct explanation of trend • correct explanation of payout ratio • correct calculations • clear explanation of recommendation

9/5/2019 2:08:03 AM

Excellent (Mark range: 12.5–16 marks) • correct evaluation of NPV, scenario and sensitivity analyses • clear recommendation and logical reasoning • logical and thorough analysis of 2 strengths and 2 weaknesses of the financial model • excellent understanding of other factors that influence project evaluation • evidence of independent research

9/5/2019 2:07:52 AM

Excellent (Mark range: 5–6 marks) Satisfactory (Mark range: 3–4.5 marks) • no errors in calculations • no errors in calculation of discount factors, NPVs or use of cash flows • no errors in spreadsheet • use of appropriate Excel formulas • 1 or 2 errors in calculations • correct D/V conversion, and cost of debt, error in WACC • correct methodology, but incorrect years • 1 error in spreadsheet

9/5/2019 2:07:29 AM

The Criteria-based Marking Guide provided at the end of each question is designed to assist students to understand what is expected of them in each question and to let them know how their performance will be judged. It provides advice about the criteria used in the marking of the question and what discriminates between an excellent, satisfactory and unsatisfactory answer.

9/5/2019 2:07:16 AM

Answers are to be in your own words. Reference and cite all your sources (within the text of your answer) when quoting or using material from external sources. Include a reference list at the end ofyour assignment. Refer to the ‘Referencing and Citations Guide’ available from the ‘Library Learning Hub’ in KapLearn for further information on referencing. • Indicative weightings are noted beside each question. Use these weightings to assist you with your allocation of time and resources. The weightings indicate the relative importance of each question. • State all assumptions used in providing your answer. • Requests for special consideration or information pertaining to special consideration written in the body ofthe assignment will not be considered by the marker. Refer to the ‘special consideration’ section of

9/5/2019 2:07:07 AM

Refer to the Criteria-based Marking Guide for guidelines on what is expected for each question. • The ‘General assessment information’ section inKapLearn contains information about format and presentation, word limits, citations and referencing, collusion, plagiarism and other policies, useful resources, submitting your assignment and accessing your results. • Full workings must be shown for all calculations. Show all calculations in the text of your assignment and NOT attached as an appendix. Appendices to assignments will not be read.

9/5/2019 2:06:54 AM

This assignment is designed to test your ability to interpret information and apply your knowledge of the issues involved in asset valuation. The data you have been provided with is intended to allow you to build a simplified but realistic model. • For Section A, you have been provided with an Excel answer template. Use this template to answer the relevant questions. Note: Some questions also require a written response in the Word document. Do not copy your spreadsheet answers into your Word document. • The overall word limit for the assignment is 3,000 words. Marks will only be awarded for answers up to the word limit (plus 10%) for each question. Any material written after this will not be counted towards your mark for that question. Headings, quotes and references within the body of the answer are included in the word count. Numerical tables, calculations, and reference lists are not included.

9/5/2019 2:06:43 AM

This assignment covers Topics 1 to 6 and accounts for 40% of your final grade. • There are three (3) sections in this assignment: – Section A comprises five (5) questions worth a total of 50 marks. – Section B comprises two (2) questions worth a total of 20 marks. – Section C comprises four (4) questions worth a total of 30 marks. You should answer all questions. • All numbers should flow through your model, but for the purposes of the assignment: – show all percentages to one (1) decimal place – show your forecasts to the nearest $.

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