Faculty of Management and Economics Accounting and Finance Department

FIN3103 Corporate Finance Problem One Mr Hassan and his family have recently moved into their new house in Taman Golf Tok Jembal. He has thought of renting out his old house in Mengabang Telipot to students of UMT. His wife on the other hand, does not like the thought of having to repair and maintain the house since damages done by students are common. So, she prefers to turn the house into a lodging property, carrying the name Akmas Homestay, wherein people can rent it out based on number of nights. Mr Hassan believes that a consistent rental income from students can be expected to be around RM700 a month. Over a period of five years, the income received from the property can accumulate to a comfortable amount that can be used to support his eldest son, Arif who is now in form 3 to enter a university. Driven by the same motive, his wife believes that they can charge up to RM200 a night to lodgers even though rental from families or travelers are irregular. She asserted that the income can be considerably more at around RM2000 during peak season such as in school holidays and wedding seasons. Having discussed further, they have both estimated the following cash flows:
Monthly Rental to students Daily Rental to lodgers Annual Income RM8,400 RM6,200 Annual Maintenance Cost RM1,000 RM300

To reach a final agreement, they have asked Arifs opinion, after all the money received from the rental property will be deposited into his SSPN account earning an interest of 4.5% p.a. Being respectful to his parents, Arif does not mind which alternative they will decide on, but he has raised a concern that the money saved in five years time may not accumulate to RM40,000 to allow a comfort tertiary education financing. His teacher always reminds that money received in the future may not be in an equivalent todays value due to inflation and decreased purchasing power. He further suggested that they should ask for advice from his uncle, Dr Hussein, a finance lecturer at UMT. Mr Hassan then went to seek advices from Dr Hussein at FPE, UMT. Dr Hussein agreed with Arif that for an investment decision to be a success, they should consider the expected return and its associated risk. For instance, he worried that carrying a name with a homestay terminology on the house can have a legal implication as the government is encouraging the actual homestay industry, while this illegal homestay properties have mushroomed over the past five years. However, he completely agrees with the idea of depositing the money into Arifs SSPN account as risk-free rate has

been around 4% annually, while the inflation rate has been fluctuated within a range between 2% and 3.5%. After a lengthy discussion, Dr Hussein came up with a new proposal of selling the house instead of renting it out. He said that the house can easily be valued at RM300,000. In fact, he himself is interested to buy the house, but currently lacks of fund. He suggested that he would like to have an option to buy the house after 8 months for RM310,000 with an option premium of RM18,000. Mr Hassan queried how he got the premium figure. Dr Hussein explained that by using the Black-Scholes model, the premium is about a correct amount as prices in the area have been increasing at a rate of 10% p.a., with an annual standard deviation of 20%. Dr Hussein then advised his brother to tell his decision after a week. Compelled by the suggestions made by his brother, Mr Hassan did a further research on discounted cash flow, time value of money and option pricing. Although not entirely convinced by the offer of his brother, Mr Hassan and his wife decided to sell the house to Dr Hussein, rather than to someone else beside their kith and kin. The decision was fuelled by the news that a highly growing local company producing seafood products is planning to expand their businesses to Middle East market; thus, Mr Hassan has planned to purchase the companys shares and bonds. The premium and principal received from Dr Hussein can be used to purchase these securities, which earning more return than a mere 4.5% SSPN interest. The seafood company is expected to pay a dividend of RM0.60 at the end of 2013, and Mr Hassan has planned to purchase the shares on the first day of the New Year. The company stresses that the current growth rate of increasing the dividend from RM0.55 in 2012 is expected to continue indefinitely. The current price of the companys shares is RM21.00 per share. The company is also issuing RM1,000,000 corporate bond with a par value of RM1,000, paying a coupon interest of 8% and will mature in five years. The bond is currently priced at RM910.00 and promises a satisfactory yield to maturity. Mr Hassan went again to tell Dr Hussein that he agrees to sell the house and tell his intention to buy the securities. Dr Hussein was delighted with the decision but stressed that his brother should calculate the intrinsic value of the securities properly before buying them. He added that using a discount rate of 12% would be appropriate. What would you do if you were in Mr Hassans shoes?