FNCE2000 Assignment: Capital Budgeting, Portfolio Analysis and CAPM

This finance report, prepared for FNCE2000, explores key financial concepts including capital budgeting, portfolio analysis, and the Capital Asset Pricing Model (CAPM). The report begins by examining relevant costs in capital budgeting decisions, calculating incremental free cash flow, and evalua...Read More

Running head: REPORT 0
introduction to finance princples
MARCH 14, 2020
STUDENT DETAILS:

REPORT 1
Part 1:
Answer 1:
At the time of evaluation of new information technology product, it is found that $ 50000
spent on the analysis of marketing. It can see that cost of marketing analysis comes under the
advertising and marketing expenses (research expenses) that are essential for the budgeting. In
this way, it can say that the cost of marketing analysis is relevant cost in the capital budgeting.
In addition, it is found that the company owned a van but it is not utilised by the
organisation. The company can rented this van for $5000 per annum for 5 years. In this situation,
the utilisation of van will be considered as relevant for the capital budgeting for the reason that
the company will use the van that is already rented. Therefore, the use of van would definitely
affect the capital budgeting (Lewellen & Lewellen, 2016).
Answer 2:
Calculation of the incremental free cash flow at the ending of year one through five –
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Incremental sales 100000
0 1200000 1440000 172800
0 2073600
Incremental operating expenses 400000 480000 576000 691200 829440
Change in depreciation 84000 84000 84000 84000 84000
Incremental free cash flow
Increased sales – increased
operating expenses + changes
in depreciation (noncash
operating expenditures) 684000 804000 948000
112080
0 1328160
Working note:
Calculation of incremental sales -
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Incremental sales =
100000*100
10000000
=12000*100
1200000
14400*10
0
=1440000
= 17280*
100
1728000
= 20736 *100
2073600
Calculation of incremental operating expenses –
Particulars Year 1 Year 2 Year 3 Year 4 Year 5

REPORT 2
Incremental
operating expenses
= 100000*40
400000
=12000*40
480000
14400*40
576000
= 17280* 40
691200
= 20736 *40
829440
Calculation of depreciation with SLM method –
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Depreciation on Computer and van
= [(400000+20000)/5] 84000 84000 84000 84000 84000
Answer 3:
Calculation of Net present value –
Particulars 0 1 2 3 4 5
Free cash flow -470000 684000 804000 948000
112080
0
132816
0
PV @ 10% 1
0.90909
1
0.82644
6
0.75131
5
0.68301
3
0.62092
1
PV of cash flow -470000
621818.
2
664462.
8
712246.
4
765521.
5
824682.
9
NPV
311873
2
Working note: Calculation of Initial investment
Particulars Amount ($)
Cost of computer 400000
Cost of van 20000
Initial cash 50000
Initial investment 470000
Calculation of payback period –
Particulars 0 1 2 3 4 5
Free cash flow
-
47000
0
68400
0 804000 948000
112080
0
132816
0
cumulative cash
flow
21400
0
148800
0
175200
0
206880
0
244896
0
Payback period 1.46

REPORT 3
Calculation of IRR –
IRR = Cash flows/ (1+r)^i - Initial investment
= 160.53%
Evaluation of project as per Net present value, payback period, and internal rate of return
–
When the organisation generates positive cash flow, then it is good condition for the
company. Therefore, the company can accept the investment. Moreover, the NPV is regarded as
the difference between present value of cash outflows and inflows that take place as the outcome
of undertaking the investment. It can see that net present value can be negative, zero or positive.
There are three possibilities related to net present value. These possibilities related to NPV are
discussed below -
(a) When present value of cash inflows < present value of cash outflows = negative
net present value
(b) When present value of cash inflows = present value of cash inflow = Zero net
present value
(c) When present value of cash inflows > present value of cash outflows = Positive
net present value
In this way, the project having positive NPV is acceptable for the company. The project
having negative NPV is not acceptable for the company. In the provided situation, it can see that
the net present value of project is 3118732. This is positive net present value. In this way, the
company can accept new IT project (Porter & South-Winter, 2017).
Further, the payback period is a period required for return on investment to equal sum of
initial investment. It is considered as period required to earn back amount made in the asset from
net cash flows. It is simple manner to assess risk of proposed investment. This period is
measured as the ratio of investment cost along with yearly earning projected from the
investments. The payback ignores TVM. Furthermore, it is useful to assess risk, since it provides
quicker image of the amount of period that initial cost will be at risk. In a case when investors
were to evaluate potential investments using payback method, in that case they would tend to
accept investment having quick payback period. It can say that that the calculation of payback
period does not cover TVM. It can see that the payback ignores cash flows beyond the payback
period. In this way, it avoids the profitability factors of the project to calculate payback period.
From the above discussion, it can see that company can get back the invested cash in asset from
cash flows within 1.45 years. It is best condition for the organisation because the organisation
should choose investment with low payback period (Simon, 2015).
Moreover, IRR is metric used in capital budgeting to estimate profitability of the possible
project. It is regarded as growth rate at which the investment is required to take. The IRR is

REPORT 4
calculated by the condition that the rate of discount is set in the manner in which NPV would be
0 for investment. In addition, it is useful in capital budgeting to make decisions whether the new
project should be considered or not be considered. It can say that the high internal rate of return
would lead high risk. Conversely, the low internal rate of return would lead low risk. In the
provided situation, it is found that internal rate of return of new IT project is 160.53%. It is
opportunistic rate for organization (Santandrea, et. al, 2017).

REPORT 5
Part 2:
Answer 1:
It can see that the share price of Amazon is increasing since past ten years. On the other
hand, the share price of Rio Tinto is not increasing from stable rate. The shares of Rio Tinto are
undervalued. It is better to prefer stocks of Amazon rather than Rio Tinto. It is better choice for
all (Song, 2018).
Answer 2:
Calculation of coefficient correlation -
Year Rio
Tinto Return Amazon return
2010 48.51 -0.35926898 125.41 -0.30209
2011 69.48 0.13905695
2 169.64 -0.13645
2012 60.46 0.06827246
6 194.44 -0.30685
2013 56.47 0.06059141
9 264.27 -0.30549
2014 53.15 0.18597828
2 358.69 0.011666
2015 44.13 0.58236292
3 354.53 -0.50423
2016 24.65 -0.597208 587 -0.33851
2017 44.79 -0.22532915 823.48 -0.56639
2018 56.11 1450.89
Coefficient correlation = 0.093013
The coefficient correlation is 0.093013. It is positive coefficient. The positive coefficient
states that while the value of one variable enhances, the value of other variable will also increase.
It indicates that the strength or relationship will increase. It appears that the portfolio consisting
of Amazon and Rio Tinto will render good diversification (Fernandez, 2019).
Answer 3:
Calculation of expected return of shares of Amazon using CAPM model -
Expected return of the shares

REPORT 6
Risk free rate 1.59%
Market rate of return 6%
Beta 1.54
CAPM 7.77%
Calculation of expected return of shares of Rio Tinto using CAPM model -
Expected return of the shares
Risk free rate 1.59%
Market rate of return 6%
Beta 0.86
CAPM 6.41%
Calculation of portfolio expected return-
Particulars Amazon
Rio
Tinto Total
Expected return 7.77% 6.41%
Weight 0.80 0.20
Portfolio expected return 6.21% 1.28% 7.49%
Calculation of Portfolio standard deviation -
Particulars Amazon
Rio
Tinto Total
Beta 1.54 0.86
Weight 0.80 0.20
Portfolio expected standard
deviation 1.23 0.172 1.40

REPORT 7
References
Fernandez, P. (2019). WACC and CAPM according to Utilities Regulators: Confusions, Errors
and Inconsistencies. Errors and Inconsistencies (February 1, 2019).
Lewellen, J., & Lewellen, K. (2016). Investment and cash flow: New evidence. Journal of
Financial and Quantitative Analysis, 51(4), 1135-1164.
Porter, J. C., & South-Winter, C. A. (2017). Accounting Basics Part 3: Time Value and Internal
Rate of Return. Radiology management, 39(1), 9-12.
Santandrea, M., Sironi, A., Grassi, L., & Giorgino, M. (2017). Concentration risk and internal
rate of return: Evidence from the infrastructure equity market. International Journal of
Project Management, 35(3), 241-251.
Simon, R. (2015). Sensitivity, specificity, PPV, and NPV for predictive biomarkers. JNCI:
Journal of the National Cancer Institute, 107(8).
Song, C., (2018). Analysis of Stock IPO Price Based on CAPM Model. Insight-Statistics, 1(1).