FNCE2000 Introduction to Finance Principles

Part 1 (25 marks) – Capital Budgeting

As a senior analyst for Lawton Enterprise, you have been asked to evaluate a new computer hardware project with the following characteristics:

• Acquiring a computer hardware for a cost of $2,500,000.
• The computer hardware has an expected six-year life.
• The initial investment in net working capital (in Year 0) is $500,000. The investment in working capital is to be completely recovered by the end of the project’s life (in Year 6).
• The computer hardware can be depreciated on a straight-line (prime cost) basis and there is no expected salvage value after six years.
• The produced software is expected to generate sales of $1,250,000 in Year 1. They grow at a 25% annual rate for the next two years, and then grow at a 10% annual rate for remaining years.
• Fixed operating expenses are $100,000 for Years 1-3 and $110,000 for Years 4-6.
• Variable operating expenses are 20% of sales in Years 1-2 and 25% of sales in Years 3-6.
• Lawton does not have any available space where the project can be located for six years and you anticipate to rent the required office space it would cost $65,000 per year for the life of the project. You expect that the project will need to hire three new software specialists at $50,000 (each specialist) per year (start in Year 1) for the full six years to work on the software.
• The project will use a van currently owned by Lawton.  Although the van is not currently being used by Lawton, it can be rented out for $20,000 per year for six years. The book value of the van is $20,000. The van is being depreciated straight-line (with six years remaining for depreciation) and is expected to be worthless after the sixth year.
• Lawton’s marginal tax rate is 35%, and the discount rate is 11.5%.

Based on the information presented above, answer the following questions.

1. (12 marks)

Calculate the incremental free cash flow during the project’s life (starting from Year 0 to Year 6).  Show workings.

2. (13 marks)

Calculate the NPV, payback period and IRR of the project. Should the project be accepted? Show workings and explain your answer(s).

Students may present the workings using the table below. Please set out your work clearly and neatly. If you choose you can take advantage of the table below or you can continue your workings on the following page which has been intentionally left blank.

Part 2 (25 marks) – risk and return

You are considering investing in stocks and have identified the following potential stocks.  They are Alibaba Group Holding Limited (BABA), Amazon (AMZN), Kogan (KGN) and China Petroleum & Chemical (386).   The table below shows the historical share prices ($) between 2016 and 2022.  Note that these prices are recorded on the 1st day of the year, for example, 1st of January 2020.  Students should assume no dividend is distributed during this period and ignore the exchange rate conversion.

1. (2 marks)

Provide a discussion on the similarities and differences of two companies: China Petroleum & Chemical and Alibaba. Minimum four key points for full marks.

Hints: students may consider the following when attempting this question.

· What services/products each company offers?

· Which industry the company operates in?

· Where their stocks are listed?

· Where the company is found?

Do not forget to cite the source of information.  Referencing (Chicago 17B referencing) is mandatory.

2. (8 marks)

Calculate the return and risk (standard deviation) of each stock.

3. (2 marks)

Explain the relation (positive or negative) between risk and return based on your answers in the previous question.

4. (4 marks)

Calculate the correlation coefficient between (1) Amazon and Alibaba, and (2) Amazon and China Petroleum & Chemical.

5. (3 marks)

Calculate the expected (annual) return and standard deviation if you owned a portfolio consisting of 50% in Amazon and 50% in Alibaba.

6. (3 marks)

Calculate the expected (annual) return and standard deviation if you owned a portfolio consisting of 80% in Amazon and 20% in China Petroleum.

7. (3 marks)

Compare the portfolios in parts 5 or 6.  Which portfolio (parts 5 or 6) provides better diversification? Define diversification and explain your answer(s).