Principles of Financial Investments

PRINCIPLES OF FINANCIAL
INVESTMENTS

TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................................................2
QUESTION 1..................................................................................................................................1
a) Calculation of the payback period for new project..................................................................1
b) NPV for the new project..........................................................................................................1
c) IRR of the new project.............................................................................................................2
d) Financial acceptability of the proposed investment based over the three appraisal method
used..............................................................................................................................................4
e) Reasons for setting lower payback period by the company of three years..............................5
f) Strengths and weaknesses of investment techniques...............................................................5
QUESTION 4..................................................................................................................................6
a) Expected return on risk assets depend over three components...............................................6
b) Standard deviation and beta measures.....................................................................................7
c) Calculation of expected return using CAPM...........................................................................8
d) Calculation of risk and return..................................................................................................9
QUESTION 5................................................................................................................................10
a) Reasons why firm is hesitant in reducing the growth rate of the dividend...........................10
b) i) Ordinary equity and its features. ii) Preference shares and its features.............................11
c) Price willing to pay for stock.................................................................................................12
d) Price of the stock with required return of 9.6%....................................................................12
e) Required rate of return with share price of €79.4 per share,.................................................12
REFERENCES..............................................................................................................................14

QUESTION 1
a) Calculation of the payback period for new project.
Cost 210000
Terminal value 45000
Calculation of the cash
flows
Year 1 Year 2 Year 3 Year 4 Year 5
Sales 80000 96000 115200 92160 46080
Maintenance cost 20000 22000 24200 26620 29282
Net Cash Flows 60000 74000 91000 65540 16798
Computation of Payback period
Year
Cash in-
flows
Cumulative cash in-
flows
1 60000 60000
2 74000 134000
3 91000 225000
4 65540 290540
5 61798 352338
Initial invest-
ment 210000
Payback pe-
riod 3
-0.2
Payback pe-
riod
2 years and 9.5
months
b) NPV for the new project
Computation of NPV
Year
Cash in-
flows
PV factor
@ 15%
Discounted
cash inflows
1 60000 0.870 52173.913
2 74000 0.756 55955
3 91000 0.658 59834
4 65540 0.572 37473
1

5 61798 0.497 30725
Total discounted cash in-
flow 236160
Initial investment 210000
NPV (Total discounted
cash inflows - initial in-
vestment) 26160
c) IRR of the new project
Step 1 : Selecting discount rates for calculation of NPVs
The discount rates 15%(R1) and 20%(R2) are taken as discount rates.
Step 2 : Calculation of the NPVs for investments using 2 discount rates.
Net Present Value at 15%
Computation of NPV
Year
Cash in-
flows
PV
fac-
tor
@
15%
Dis-
counted
cash in-
flows
1 60000 0.870 52173.913
2 74000 0.756 55955
3 91000 0.658 59834
4 65540 0.572 37473
5 61798 0.497 30725
Total discounted cash in-
flow 236160
Initial investment 210000
NPV (Total discounted
cash inflows - initial in-
vestment) 26160
Net Present Value at 20%
2