Institute of Actuaries of India 2008 CT-2 Finance and Financial Reporting - Question Paper

• The company's tax rate is 40 percent.
• The company anticipates issuing new common stock during the upcoming year.
What is the company's WACC? [10]

b) A large multinational insurance company is considering a major international
expansion. The directors of the company are considering investing heavily in a
feasibility study in order to determine whether to begin their operations in a new
country. There are many factors that would determine the success or otherwise
of this new venture. For example:
• The fixed costs may be high as it may be difficult to get suitable staff without
offering very substantial salaries.
• It is difficult to predict how competing firms who are already established in that
country will respond to the competition.
• The new host country's currency is very volatile compared to the company's
home currency and all profits from the new office would be earned in that host
currency.
The feasibility study is a very costly undertaking in itself and so the firm is
considering the respective merits of the subsequent 3 options:
• Conduct a feasibility study, prior to making a decision to whether proceed.
• Proceed with the expansion without 1st undertaking a feasibility study.
• Abandon the whole idea of the expansion.
One of the directors of the firm has prepared a probability tree using the subsequent
assumptions:
• If the expansion goes ahead it will yield either of the subsequent outcomes:
Success (with a positive net current value (NPV) of INR 50 lacs) and Failure
(with a negative NPV of INR 10 lacs)
• The feasibility study will cost INR 100,000 and will have an 80% probability of
correctly predicting the result of the expansion.
• There is a 70% probability that the feasibility study will indicate that the
expansion will succeed and a 30% probability that it will indicate failure.
• If the expansion proceeds without the feasibility study it has a 62% probability
of success and a 38% probability of failure.
Using these assumptions 1 of the directors of the company has prepared the
subsequent probability tree and claims that the expansion is likely to prove successful,
but the firm should undertake the feasibility study nevertheless.

a different director has prepared a simulation of the investment and has simulated the
result of proceeding for 10,000 cycles. This suggests that the expected net current

Earning:   Approval pending.