Reference no: EM133065144

Financial Management

Question 1

a) Explain the difference between an American and a European option. Provide an example, how an Australian company could use a European put option to hedge their risks.

b) A Bermudan option is a special kind of option that usually has one exercise date per month for the duration of the option. If you were wanting to purchase a 6 month Bermudan call option but one was not available on the market, how could you create one using either American or European Options?

c) Draw a ↑ or a ↓ to indicate what the effect of the following circumstances would do to the value of a Put Option.

An increase in the exercise price of the option.

An increase in the spot price of the underlying asset.

An increase in the volatility of the underlying asset

A decrease in the term to maturity of the option.

The option moves from at the money to deep out of the money

Question 2

The Stanmore Window Cleaning Company is looking to purchase a new vehicle for one of its employees. The options available to them are:

i) Hyundai i20 which will cost $20,000 to purchase, have running costs of $1000 a year and last for 6 years,
ii) A Mitsubishi ASX which will cost $30,000 to purchase, have running costs of $500 a year and last for 10 years.

Assume a discount rate of 10%
a) Calculate the PV of the total cost of both the Hyundai and the Mitsubishi

b) Calculate the EAC for both vehicles. Which vehicle represents a better alternative for the Stanmore Window Cleaning Company?

c) Describe the two limitations of the payback period as a capital budgeting evaluation tool.

Question 3

For each of the following events, state the effect on each of the items listed below. Draw an up arrow (↑) for an increase, a down arrow for a decrease (↓) and a blank space or dot for no change.

Question 4

TerraNova Investments is trying to determine its cost of capital.

The company just paid a dividend of $2 and expects to achieve growth of 4% p.a. on their ordinary share dividends. The current market price of the share is $15. The standard deviation of the stock is 7% and the β is 1.3. The risk free rate is 4%. There are currently 4 million shares on issue.

The company also has debt with a maturity of 20 years that pays annual coupons. The coupon rate is 11% and the bond was issued with a face value of $1000 and is currently priced at $1000. There are presently 15,000 bonds on issue.

Preference shares have a market price of $100 and pay an annual dividend of 10%. The issue price of the preference shares was $200. When the share was issued at face value the value of the stock issued was $2m.

The company tax rate is 30%.

(a) Calculate the weights of the ordinary shares, bonds and preference shares that would be used in a WACC calculation for SIP Ltd.
(b) Calculate the cost of equity of the ordinary shares.
(c) Calculate the cost of debt on an after tax basis.
(d) Calculate the cost of equity for the preference shares.
(e) Calculate the WACC on an after tax basis.

Question 5

a) Describe what is meant by the degree of accounting operating leverage for an organisation.
b) Describe how an organization may use the accounting degree of operating leverage measures when considering upgrading a process.
c) The Smithsonian pen company has the opportunity to invest in a new pen making facility. There are two options. The large factory will have fixed costs of $5m and annual depreciation of $1m while the small factory will have fixed costs of $2m and annual depreciation of $200,000. The pens will sell for $15 each. The small factory will produce these for $11 and the large factory for $7. Calculate the Ebit and the Ebitda crossover level of sales.