Financial Questions and Client Investments in Business Finance

This report answers financial questions related to NPV, risk and return, portfolio theory, and capital budgeting. It also provides advice to clients on investments in Lloyds Ltd stock and RunRig Ltd. The report recommends investing in Project 2 for a telecommunication sector start-up company.

BUSINESS FINANCE
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Introduction
The objective of the given report is to answer the financial questions with regards to different
aspects of NPV coupled with risk and return related discussion. In this regards, reference has
been given to the portfolio theory and theoretical underpinnings related to capital budgeting.
Additionally, the client investments have also been critically analysed in order to provide
advice to the client with regards to the appropriate choice so as to maximise returns on the
investments at hand. A key limitation is that the analysis has been based on standard
assumptions related to NPV and other valuation models such as dividend discount model
which may not be true.
Financial Questions
1) The central tenet of portfolio theory is that the risk and return tend to be correlated. It is
based on the assumption that investors are risk averse and therefore to invest in a risky asset
class, compensation is required in the form of higher returns. The stock market investments
need to be viewed in the backdrop of portfolio theory. The average returns of the stock
market tend to exceed the average returns of lower risk class assets such as bonds. This
indicates towards higher risk being present which need to be properly managed to reduce
exposure (Damodaran, 2015).
With regards to stocks, there are two types of risks namely systematic risk and unsystematic
risk. Systematic risk is also called as non-diversifiable risk as it is a general risk associated
with market investment and cannot be mitigated using portfolio or diversification. On the
other hand, unsystematic risk is the diversifiable risk and therefore can be managed by
diversification of the portfolio. In this regards, it is noticeable that the risk associated with the
stock is captured by the standard deviation of the stock returns. Through diversification, there
tends to some natural hedge and hence the deviations from mean is lowered which enables
lowering of risk (Northington, 2015).
In order to maximise the benefits of diversification, it is essential that the portfolio must
contain of stocks that are negative correlated since this tends to reduce the diversifiable risk
component to almost zero. For example, comprising the portfolio of a company which
exports goods and one which imports goods would make the portfolio stable in time of
volatile currency. However, through perfect diversification also, risk cannot be made zero
since systematic risk would still be present which would be captured using beta. This term

represents the underlying risk associated with the portfolio or stock and is used to deriving
expected returns (Petty et. al., 2015).
2) There are two main conditions which ought to be fulfilled in order to ensure that WACC of
the firm is used for assessing new projects. One key requirement is that the new project
should have similar risk profile in comparison to the firm as a whole. If the project has higher
or lower risk in comparison to the average risk of the firm, then the WACC also needs to be
revised upwards or downwards respectively. This is because the underlying returns expected
on funding would be dependent on the perceived risk of the project (Parrino and Kidwell,
2014).
Another key aspect is that the capital structure related to funding the project should match the
existing capital structure of the firm. IF there is any significant difference in this regards, then
the firm WACC cannot be used for the project (Brealey, Myers and Allen, 2014).
3) a) The decision rule for NPV is that the project which has a positive NPV must be
selected. However, in case of mutually exclusive projects, even if a project has positive NPV,
it may not be selected as the alternative project may have a higher positive NPV. Thus, for a
project with positive NPV to be selected, it is imperative that the company should have
enough resources particularly finance for implementing the project. In case of shortage of
finance, projects having the highest positive NPV are selected and those at the lower end are
ignored (Arnold, 2015).
b) Depreciation is essentially an accounting cost which is not actually incurred thereby
implying that there is no cash implication as it is not paid in cash by the company.
Depreciation essentially captures the wear and tear in the fixed assets which causes a decline
in their book value. However, with regards to NPV, depreciation is considered owing to the
tax shield that it provides which is relevant considering the fact that NPV considers the post-
tax cashflows (Damodaran, 2015).
c) The tax savings on interest payments are excluded as the cost of debt taken into
consideration for the computation of WACC is already post tax and hence the tax savings are
already reflected in the form of lower cost of debt which essentially leads to lower value of
cost of capital (Parrino and Kidwell, 2014).
d) Sunk costs are not taken into consideration for the purpose of NPV analysis as irrespective
of the decision made regarding the project, these costs cannot be recovered. Hence, these

costs are not incremental costs since they cannot be altered with regards to the decision to go
ahead with the project or drop the project. If these are considered, then the NPV would be
revised to a lower value and may lead to incurred decision being made (Petty et. al., 2015).
Client Investments
1) The first step is to compute the required return on equity for the Lloyd stock which would
require the use of CAPM Model (Arnold, 2015).
Required return on equity = Risk free rate + Beta*Market Risk Premium
Considering the given data, the following computation can be made.
Required return on Lloyd share = 4 + 1.4*(10-4) = 12.4 %
In order to estimate the fair price of the stock in 2017, it is imperative to use the Gordon
Dividend approach highlighted below (Brealey, Myers and Allen, 2014).
Intrinsic share price = Next year dividend/( Required return – Perpetual growth of dividend)
Thus, based on the dividend history, the next year dividend and also the dividend growth rate
till perpetuity ought to be determined.
It is apparent from the dividend history of the company that the dividend in 2010 was $ 0.3
while the corresponding value in 2016 stands at $ 0.5.
Hence, dividend growth rate = [(0.5-0.3)/0.3]*100 = 66.67%
However, the above growth has been achieved over a period of 6 years, hence annual growth
rate = 66.67/6 = 11.11%
Expected dividend in 2018 = 0.5*1.1111 = $ 0.5556
Expected stock price at the end of 2017 = 0.5556/(0.124 -0.111) = $ 43.06
Expected stock price at the end of 2016 = 43.06/1.124 = $ 38.3
It is apparent that at the existing price the stock is strongly undervalued and hence it makes
sense to invest in the given stock (Northington, 2015).

2) a) The various assumptions related to dividend growth model are indicated as follows
(Petty et. al., 2015).
 The growth rate of dividend would remain constant and would not alter in the future.
 The company would continue to pay the requisite dividend in every year and would
skip any year.
 The cost of equity for the future years would continue to remain the same.
b) Current price of preference shares = $ 8.65
Total preference shares = 100,000
Hence, market value of preference shares = 8.65*100000 = $ 865,000
Current price of common share = $ 2.95
Total common shares = 500,000
Hence, market value of common shares = 2.95*500000 = $1,475,000
The market debt of debt can be computed as indicated below.
Total capital = Sum of market value of debt, preference shares and common shares = $
5,456,689.54
Weight of preferences shares = 865000/5,456,689.54 = 0.1585
Weight of ordinary shares = 1475000/5,456,689.54 = 0.2703
Weight of debt = 3116689.54/5,456,689.54 = $ 5712
c) The tax rate is given as 30%. New debt would be issued at 9% interest rate.
Hence, after tax debt cost = 9% (1-0.3) = 6.3%
Cost of preference shares = (Dividend/Market Price) = (1.20/8.65) = 13.87%
Cost of equity can be computed using the Gordon dividend approach.

Cost of equity = (0.25*1.04/2.95) + 0.04 = 12.81%
d) The WACC computation is indicated below.
WACC = 12.81% * 0.2703 + 13.87% * 0.1585 + 6.3%* 0.5712 = 9.26%
3) In the given case, since the life of the two projects is different, hence the NPV of the
projects would be used to compute the equivalent annual annuity using the formula indicated
as follows (Damodaran, 2015).
Project 1 Equivalent Annual Cash Flow
Initial outlay = $ 13 million
Annual cash flows = $ 3.5 million
System life = 8 years
It is assumed that the annual cash flows tend to take place at the end of the year.
The present value of annuity can be found using the following formula (Parrino and Kidwell,
2014).

For the given case, P = $ 3.5 million, r=14%, n= 8 years
NPV = [3.5 *(1-1.14-8)/0.14] – 13 = $ 3.24 million
Equivalent annual cash flow = 0.14*3.24/(1-1.14-8) = $ 0.697 million
Project 2 Equivalent Annual Cash Flow
Initial outlay = $ 18 million
Annual cash flows = $ 6 million
System life = 5 years
It is assumed that the annual cash flows tend to take place at the end of the year.
The present value of annuity can be found using the following formula.
For the given case, P = $ 6 million, r=14%, n= 5 years
NPV = [6 *(1-1.14-5)/0.14] – 18 = $ 2.60 million
Equivalent annual cash flow = 0.14*2.60/(1-1.14-5) = $ 0.700 million
Recommendation
Based on the above analysis, it is apparent that the preferred project would be Project 2 as it
has a higher equivalent annual cash flow. Hence, the company must invest in this project.
Conclusion & Recommendation

From the above discussion, it can be concluded that diversification tends to reduce the stock
risk by eliminating the unsystematic risk. The client is recommended to invest in Lloyds Ltd
stock as currently the stock is highly undervalued. Also, with regards to RunRig Ltd, the
WACC has been computed as 9.26% by considering the individuals weights and costs of
individual sources of financing. In relation to the telecommunication sector start-up company,
it would be preferable to invest in Project 2 as the equivalent annual cash flows would be
greater in this case.

References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management.
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley,
John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publication
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia