Hill Ltd. is considering updating their systems, which will cost $100,000. The new system will be depreciated prime cost to zero over its 5-year life. It will probably be worth about $20,000 after 5 years.

The new machine will save $20,000 per year in operating costs. The tax rate is 30 per cent, and tax is paid in the year of income.

Hill Ltd. has several classes of outstanding bonds, and the average yield is 6%. Its beta is 1.3, historical market risk premium is 7.94%, and the treasury yield is 4%.

Please use the above information to answer questions 11 to 16.

Question 11

What is the required rate of return for Hill?

[5 marks]

Question 12

There is a put option on Hill shares with an exercise price of $30. If we expect the Hill share price to be $25 at the option expiry date in six months, what will be the pay-off from the put option?

Question 13

If the risk-free rate was currently 2 per cent and the share return volatility (variance) of Hills ordinary shares was 5.00 per cent per annum, what would be the traded price of the Hill put option?

Question 14

If Hills capital structure is 40% debt and 60% equity, what is Hills cost of capital (WACC Weighted Average Cost of Capital)? Explain your answer.

Question 15

Should Hill Ltd purchase the new system? Show your analysis using the capital budgeting techniques you have learned in this unit, and explain your answer.

Question 16

If you hold $10,000 Hill shares, and plan to buy additional shares of ABC worth $5,000. The expected return for ABC is 5%. What is the expected return for your portfolio including both Hill and ABC? (Hint: use the required rate of return computed in Q1)

Question 17

Consider the following information:

State of the economy	Probability of state of economy	Return on A (%)	Return on B (%)
Boom	0.2	10	5
Growth	0.3	-2	0
Normal	0.3	20	15
Recession	0.2	15	20

1. What is the expected return for A? For B? [5 marks]
2. What is the standard deviation for A? For B? [5 marks]
3. What is the expected return and variance of a portfolio that is 50 per cent invested in A and 50 per cent in B? [5 marks]