Explain how the time value of money has an impact

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Case Study 1-

Companies listed on the Australian Securities Exchange (ASX) are increasingly using seasoned equity issues, in the form of rights issues or private placements of additional equity securities, in preference to raising capital using private or public debt markets. One example of a seasoned equity raising on the ASX is the renounceable rights issue announced by Macarthur Coal Ltd on 9 March 2004. Macarthur Coal Ltd is a coal-mining, processing and exploration company that is currently operating the Coppabella and Moorvale mines in Queensland and is focused particularly on the development of new generation coal resources in Queensland's Bowen Basin. The company's current corporate strategy is centred on achieving organic growth through the development of new coal mines from grassroots level and identifying and pursuing projects in high-growth coal market segments.

The offering involved the issue of approximately 25.8 million additional shares in Macarthur Coal Ltd at a subscription price of $1.20 for each new share via a pro-rata renounceable rights issue to raise approximately $31 million. The rights issue gave shareholders the right to buy one new share for every five shares held at the record date (18 March 2004). As the rights issue was renounceable, those shareholders not interested in taking up their rights could trade them on the market between 12 March and 30 March 2004.

The rights issue was also accompanied by a 'top-up facility', allowing shareholders who accepted the offer to apply for additional shares at the subscription price. This top-up facility would only be activated if some rights holders chose not to participate in the rights offering and the desired number of shares (25.8 million) was not issued by way of the rights issue. As such, the top-up facility would only apply if there were unsubscribed shares at the closing date of acceptances for the rights issue (6 April 2004). Any remaining shares not allocated via the top-up facility would be issued to the offer underwriter and, in the case of the top-up facility being oversubscribed, shares would be issued on a proportional basis among shareholders participating in the top-up facility. The prospectus for the rights issue indicated that the proceeds would be used for:

  • partial repayment of the debt finance facility utilised to fund the acquisition of an additional 23.3 per cent interest in the Coppabella Mine in December 2003
  • provision of working capital for the increase in attributable coal production proposed for the Coppabella and Moorvale mines
  • evaluation of other growth projects.

The closing share price of the company on the trading day prior to the rights issue announcement (5 March 2004) was $1.48 and the closing share price on the rights offer  record date (18 March 2004) was $1.50. The closing share price on the last day of cum-rights trading (11 March) was $1.44 and the opening share price on the ex-rights date (12 March 12004) was $1.42. Being the holder of record at 5:00 pm on 18 March 2004 entitled shareholders to participate in the rights issue process. However, to be recorded as a shareholder on the record date an investor would need to purchase the shares on or before the close of trading on 11 March 2004, the last day that the shares traded on a cum- rights basis.

Questions:

1. Based on the case study information provided, determine the value of each right provided by Macarthur Coal Limited and the theoretical ex-rights price of the shares. Compare this theoretical ex-rights price with actual prices on the ex-rights date and explain the possible reasons for any differences observed.

2. Consider the information provided regarding the planned usage of the proceeds of the rights issue. Outline whether these suggested fund uses are consistent with the characteristics associated with equity as a source of financing.

3. Outline possible reasons for the inclusion of the top-up facility as a component of the rights issue.

Case study 2-

The focus on superannuation and encouraging individuals to save and invest for their future, and particularly their retirement years, has been intensifying in Australia in the past two decades. The Australian Government has been especially proactive in this regard, mandating minimum contributions to be made to complying superannuation or retirement funds by employers on behalf of their employees. This minimum level of employer contribution to superannuation was introduced at 3 per cent of employees' salaries and has since increased to a minimum contribution of 9 per cent. Employees are also compelled to allocate a percentage of their income to superannuation investment. The impetus for introducing these superannuation policy initiatives was the need to remove the burden from the social security system for the provision of pension payments to support individuals during the retirement stage of their lives. Owing to these superannuation laws and an increasing realisation by individuals of the importance of saving for their future, there are currently billions of dollars of superannuation contributions flowing every year to  superannuation funds and financial institutions, whose role it is to profitably invest these contributions to provide sufficient income to fund the non-working component of individuals' lives. As such, superannuation and mutual funds are one of the largest investors in Australian financial markets, particularly in equity securities of companies listed on domestic and overseas share markets.

One of the largest individual, industry-based superannuation funds is UniSuper Ltd, which services and manages superannuation for employees in the tertiary education sector in Australia, including universities, TAFE colleges and other higher education institutions. The other revolution in superannuation funds management and service provision in recent years has been a significant increase in the variety of superannuation fund products and investment and retirement plan options, with members now having much greater flexibility in deciding what types of funds and assets their superannuation contributions are invested in. In line with this increasing investment choice, UniSuper Ltd offers its members two forms of superannuation plans:

  • a Defined Benefit Plan
  • an Investment Choice Plan.

As the name suggests, the Defined Benefit Plan is one where the benefit paid to employees at retirement is determined using a formula, which factors in determinants such as employees' final average salary, age and the number of years that they have been employed. Under the Defined Benefit Plan, employees' retirement benefit is calculated as:

Retirement benefit = benefit salary x length of membership x lump-sum factor x average service fraction

For tertiary education employees who elect to adopt the Defined Benefit Plan, their superannuation contributions are pooled and invested in a selection of assets determined by the UniSuper Ltd trustees. As their final benefit payout is determined solely by the above formula, the investment performance of their asset portfolio is effectively irrelevant and does not affect their final retirement payout: the investment risk is borne solely by UniSuper Ltd. This implies that employees do not benefit from gains earned by their asset portfolio (above the minimum requirement to meet their defined benefits) and it is the responsibility of the UniSuper Ltd trustees to be able to fully fund these defined benefits. The trustees of the Defined Benefit Plan do have the discretion to pay an additional accumulation benefit on an annual-adjusted basis, although this is not guaranteed and will form a small proportion of overall superannuation benefits under this plan.

Those employees who choose the Investment Choice Plan retain an individual investment account comprising employer-sponsored and personal superannuation contributions and an annual distribution of gains earned on their invested contributions, less any administration  and management charges. Under the Investment Choice Plan, employees can nominate the types of assets or portfolios that their superannuation contributions are invested in, choosing between the following four investment strategies:

  • Secure Fund: Australian fixed-interest securities and cash.
  • Stable Fund: Primarily fixed-interest and bond securities, with a small exposure to domestic and overseas shares and property.
  • Trustees' Selection Fund: Balanced fund of domestic and overseas shares, property assets and infrastructure and private equity investments.
  • Shares Fund: Investment solely in domestic and overseas shares.

These strategies are distinguishable by their risk and return characteristics, with the Secure Fund being the least risky and likely to provide the lowest average return and the Shares Fund carrying the highest risk but being expected to provide the highest overall average return. For employees who choose the Investment Choice Fund, their final retirement payout is dependent on the returns generated by their chosen investment strategy and they bear the associated investment risk.

At the time of retirement, UniSuper Ltd provides a range of investment products for both Defined Benefit Plan and Investment Choice Plan subscribers to manage and distribute their retirement benefits. These include the following pension and other investment options:

  • Indexed Pensions: provide a regular income that is indexed to inflation, is payable as long as you live and is transferred to a spouse or dependent upon your death.
  • Single Life Indexed Pensions: provide a higher regular income compared with the standard indexed pension outlined above, but are not transferred to a dependent upon your death.
  • Allocated Pensions: provide a regular income (at a level of your choosing), access to your capital, if desired, and four available investment strategies according to which your capital can be invested. If you die, the balance of the pension is distributed to your dependants.
  • Roll-over Options: give you the choice to transfer (roll over) your retirement fund balance to an approved personal or industry superannuation or investment fund, an approved deposit fund or a retirement savings account.
  • Part-Cash Distribution: give you the option to take a certain percentage of your retirement fund (subject to regulatory and tax approvals) as a cash lump sum to be used for investment or personal consumption purposes.

Participants can also choose a combination of these alternatives, with a careful view to meeting their income and lifestyle requirements in retirement. Within this decision-making process, considerations of investment risk and return profiles are paramount, as are factors such as the effects of inflation and the time value of money.

Questions-

1. Outline what you think are the important factors that should be considered by tertiary sector employees when they are deciding whether to place their superannuation contributions in the Defined Benefit Plan or the Investment Choice Plan. What issues relating to the concept of the time value of money may be important in this decision- making process?

2. Explain how the time value of money has an impact on the potential investment returns and retirement savings of participants in both the Defined Benefit Plan and the  Investment Choice Plan. Would you be correct in saying that participants who opt for the Defined Benefit Plan are foregoing potential gains in investment earnings and returns generated in connection with the time value of money?

3. Consider the retirement investment products that are offered to members by UniSuper Ltd. In terms of time value of money concepts and ideas, which of the available alternatives do you think would be most attractive? Explain the reasoning for your choice, using examples of present or future values calculations, if required.

Case study 3-

On account of the high management fees and recent poor return performance associated with his employer-sponsored superannuation fund, Les Risky has decided to supplement these savings by starting his own self-managed investment fund. Les considers himself to be relatively knowledgeable regarding financial markets, including the share market and thinks that he can identify profitable share investments as well as so-called professional fund managers can. Les plans to start this investment fund with $10 000 of his own savings and will allocate an additional $100 per week from his salary to expand the fund's holdings and investments.

Les has decided to concentrate on investing in shares listed on the Australian Securities Exchange (ASX), as he is most familiar with this market and believes that shares will provide a higher long-term return than other investments such as property or infrastructure assets. At the moment he is weighing up two possible investment strategies to apply to his investment funds. These are:

  • to invest directly in a portfolio of individual company shares from a variety of industry sectors, which h plans to personally research and choose.
  • to invest indirectly in Australian company shares through industry-managed funds (such as Colonial First State, ING Australia, AXA Australia Investments, Bankers Trust and Macquarie Managed Investments). These funds normally invest in a diverse portfolio of shares tracking a particular performance indicator, such as the All Ordinaries Index or the S&P/ASX 200 index.

As a result of Les's disappointment with the performance of his employment-based superannuation plan, which has a similar profile to the second strategy just listed, Les is favouring the first idea of stock-picking his own personal portfolio of company shares. After some initial research, Les has narrowed his list of preferred investments to the following companies:

Company name

ASX code

Industry sector

National Australia Bank Ltd

NAB

Banking and finance

Coca-Cola Amatil Ltd

CCL

Food and household goods

James Hardie Industries Ltd

HAH

Building materials

Lend Lease Corporation Ltd

LLC

Developer and contractor

News Corporation Ltd

NCP

Media

Sons of Gwalia Ltd

SGW

Gold mining

Westfield Trust Ltd

WFT

Investment company

Woodside Petroleum Ltd

WPL

Oil and gas exploration

Les has intentionally chosen companies from a range of different industry sectors to try to maximise the potential diversification benefits in forming his investment portfolio, and will look to widen the number of companies included in his portfolio as he invests more funds in the portfolio through his salary contributions.

As part of Les's preliminary analysis of desirable company investments, he accessed historical share price information on his chosen companies and calculated total return and standard-deviation measures for the last financial year (from 1/7/00 to 30/6/01), and beta coefficients for prediction purposes using individual share and market-return data for the previous financial year (from 1/7/99 to 30/6/00):

 

 

 

Company name

 

 

 

Total share return

Standard deviation of daily returns

 

 

 

Beta coefficient

National Australia Bank

10.97%

1.62%

0.906

Coca-Cola Amatil

-62.78%

2.73%

0.718

James Hardie Industries

9.28%

2.07%

0.626

Lend Lease Corporation

2.69%

1.75%

0.683

News Corporation

57.90%

3.42%

2.625

Sons of Gwalia

27.77%

2.45%

0.349

Westfield Trust

5.81%

1.04%

0.381

Woodside Petroleum

23.96%

2.08%

0.778

 

 

 

 

All Ordinaries Index

12.28%

0.92%

1.000

Using this daily return information, Les also attempted to determine the relationship between the daily share-price movements of these companies by calculating their relative correlation coefficients:

 

NAB

CCL

HAH

LLC

NCP

SGW

WFT

WPL

NAB

1.000

0.150

0.211

0.176

0.117

0.163

0.309

0.187

CCL

 

1.000

0.253

0.091

-0.001

0.139

0.323

0.218

HAH

 

 

1.000

0.075

0.111

0.101

0.200

0.212

LLC

 

 

 

1.000

0.118

0.184

0.198

0.109

NCP

 

 

 

 

1.000

0.002

0.116

0.120

SGW

 

 

 

 

 

1.000

0.124

0.041

WFT

 

 

 

 

 

 

1.000

0.176

WPL

 

 

 

 

 

 

 

1.000

Les has found this information useful for evaluation purposes, but owing to the short time frame of the information he is uncertain about its reliability, and the likelihood that similar share returns will be provided by these companies in future years. He does, however, accept that he could invest in an index-matched managed fund and earn an average long-term return similar to that provided by the All Ordinaries Index. Les is also concerned about the potential risk exposure associated with a small portfolio of shares and is looking to minimise the risk of his portfolio as much as possible.

Les is now at the stage of finalising his initial investment choices and structuring his investment fund, and he has asked for your advice in answering the following questions:

Questions-

1. Traditional risk and return concepts suggest that a positive relationship should exist between the risk associated with an investment security and the relative return that it provides to the holders. Review the return and standard-deviation information provided in the first table above, and outline whether Les's selected companies provide results consistent with this expected positive relationship between risk and return. Specify any companies that appear to violate this relationship and should be rejected as investment choices by Les. Also, outline whether the concept of portfolio theory holds-that portfolio risk is minimised by holding a well-diversified portfolio of shares (such as the All Ordinaries Index portfolio).

2. Les has decided to construct his initial portfolio employing equally weighted investments in three of his chosen company shares. Using the above information, recommend to Les the three company shares that he should invest in, taking account of his desire for a portfolio return at least equivalent to that of an index-matched fund while also minimising his risk exposure. Using the historical information provided for the 2001 financial year, calculate the actual return and standard deviation of this portfolio. Does it outperform the market-wide All Ordinaries Index over this period? Use the Sharpe and Treynor ratios to evaluate the portfolio on a risk-adjusted basis by benchmarking against the All Ordinaries Index (Note: the average return on 90-day bank bills was 5.20 per cent over this period).

3. As a check on his company selections, Les would like to review the performance of his chosen companies, over this period, against a well-respected asset pricing model. Apply the capital asset pricing model (CAPM) equation, using the data provided above, to predict the expected returns of these shares for the 2001 financial year. Compare the companies' actual return performance with that expected by the CAPM, and outline what these results suggest about the accuracy of the CAPM as a return-estimating model. Do your portfolio selections agree with the results of this CAPM evaluation?

Reference no: EM131042927

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