Reference no: EM133071714

Question 1

(a) Helen Ong (Helen) runs a hairdressing business from her home and the business has expanded, with revenue now reaching RM40,000 per year. Helen is considering moving her business to a town centre premises, and employing another hairdresser, who would cost RM6,000 per year. She has found the premises that could be rented for RM3,500 per year.

Currently, Helen advertises her hairdressing business operations in the local newspapers and business directories, at a cost of RM1,000 per year. Helen needs to carry on with this advertising, but in order to improve her business, she will also need an additional 'one off' advertising to promote the move to the new premises, and to inform the customers of the new hairdresser joining the business. This 'one off' advertising in the local newspapers will cost RM2,000 payable in the first year. Helen has to buy new salon fittings and equipment costing RM4,000 for the new premises.

Helen believes that having a town centre presence and the associated publicity in the local newspapers will increase revenue by 40% in the first year and it would remain at this new increased level for the next four years. Overheads, excluding advertising and rental expenses, would increase to a total of RM4,000 per year.

Overheads currently charged to the business are RM1,500 per year. Annual direct costs such as shampoo costs are budgeted at 5% of the annual incremental revenue.

Required:

(i) Assuming that the cost of capital is 10% per annum, conduct a five-year analysis using the Net Present Value method and advise Helen as to whether or not she should move her business to the new premises.

(ii) If Helen also advertises on the local radio costing RM5,000 which will be paid immediately, she believes that revenue would increase by 45%, rather than 40% in the first year, and would again remain at this new increased level for the next four years. Annual direct costs remained at 5% of annual incremental revenue.

Calculate a net present value over a five-year time period, that justifies the additional advertising rather than advertising in the newspapers alone.

(iii) Helen will only accept investments that are recoverable within a payback period of 3 years.

Based on the calculation in part (i) above, determine whether Helen should move her business to the new premises.

(iv) Explain how sunk costs and cannibalisation affect the determination of an investment's incremental cash flows.

(b) With respect to capital budgeting decisions, explain the terms "mutual exclusivity", "replacement decisions" and "retirement decisions".

(c) Explain briefly the key steps that should be included in a company's capital budgeting process.

Question 2

(a) John is a shareholder of Carson Construction (Carson) and owns 100 shares of Carson. The board of directors of Carson recently announced a 20% stock dividend to all shareholders on record as at 30 Sept 2021. Assuming that Carson's current stock price is RM30 per share and there are 1,000,000 shares of stock in issue of RM1 par value, and its earnings per share (EPS) for last year was RM1.50.

Required:

(i) Calculate the market capitalisation and earnings per share of Carson before and after the stock dividend.

(ii) Based on the calculations in part (a) (i) above, explain the impact of the stock dividend on John's ownership position and the market price of his stock investment in the company.

(b) If, instead of announcing a 20% stock dividend, Carson declares a 3-for-2 stock split, and assuming that Carson's current dividend is RM0.60 per share:

(i) Calculate Carson's market capitalisation, dividend yield, dividend per share and earnings per share before and after the 3-for-2 stock split.

(ii) Based on the calculations in part (b)(i) above, explain the impact of the 3-for-2 stock split on the shareholders of the company.

(c) Explain the possible effects of cash dividends, stock dividends and stock splits on the financial ratios of a company.

(d) Some firms use stock splits and stock dividends to keep stock prices within a perceived optimal trading range of RM20 to RM50.
Briefly explain the "optimal trading range" hypothesis.