WORKSHOP QUESTIONS:

Finance & Financial Management

CAPITAL BUDGETING

Question 1: Having proven yourself to be a superior student (your choice of this course
being a case in point) your university offers you a choice between an
outright gift of $1,000 or a $7,000 interest free loan to be paid back in
seven equal annual installments of $1,000 each. Assume that there is
only one interest rate in the market, denoted by R.

(a) Which alternative would represent the optimal choice for you?
Explain your decision.

(b) Under what circumstances would you reverse your choice? Be

specific. (Use a graph to illustrate your answer).

Question 2: A company is confronted by the following two mutually exclusive

investment opportunities:

------------------------------------------------------------------------------------------
Year 0 1 2 3 4
------------------------------------------------------------------------------------------
Project A -80,000 28,000 28,000 28,000 28,000
Project B -24,000 9,800 9,800 9,800 9,800
------------------------------------------------------------------------------------------------------------

(a) The NPV and IRR may lead to different decisions when the
projects are mutually exclusive. Explain.

(b) Assuming a cost of capital of 10%, calculate the NPV and the IRR
of each project.

(c) Which of the two projects would be chosen according to the NPV
criterion? Which according to the IRR?

(d) How can you explain the differences in rankings given by the NPV
and IRR methods in this case?

(e) Describe the hypothetical cash flow ‘A minus B’ and calculate its
NPV and IRR. Use this result to ‘defend’ the NPV decision.

(f) Graph the NPV of each project (including the project ‘A-B’) as a
function of the discount rate.
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Question 3: Amble plc is evaluating the manufacture of a new consumer product. The
product can be introduced quickly, and has an expected life of four years
before it is replaced by a more efficient model. Costs associated with the
product are expected to be:

Direct Costs (per unit)

Labour: 3.5 skilled labour hours at $5 per hour
4 unskilled labour hours at $3 per hour

Materials: 6 Kilos of material Z at $1.46 per kilo

Three units of component P at $4.80 per unit
One unit of component Q at $6.40
Other variable costs: $2.10 per unit
Indirect Costs
Apportionment of management salaries $105,000 per year
Tax allowable depreciation of machinery $213,000 per year
Selling expenses (not including any salaries) $166,000 per year
Apportionment of head office costs $50,000 per year
Rental of buildings $100,000 per year
Interest charges $104,000 per year
Other overheads $70,000 per year (including apportionment of building
rates $20,000. N.B. rates are a local tax on property).

If the new product is introduced it will be manufactured in an existing

factory, and will have no effect on rates payable. The factory could be
rented for $120,000 per year (not including rates), to another company if
the product is not introduced.

New machinery costing $864,000 will be required. The machinery is to be

depreciated on a straight-line basis over four years, and has an expected
salvage value of $12,000 after four years. The machinery will be financed
by a four year fixed rate bank loan, at an interest rate of 12% per year.
Additional working capital requirements may be ignored.

The product will require two additional managers to be recruited at an

annual gross cost of $25,000 each, and one manager currently costing
$20,000 will be moved from another factory where he will be replaced by
a deputy manager at a cost of $17,000 per year. 70,000 kilos of material Z
are already in stock and are not required for other production. The
realisable value of the material is $99,000.

The price per unit of the product in the first year will be $110, and demand
is projected at 12,000, 17,500, 18,000 and 18,500 units in years 1 to 4
respectively.

The inflation rate is expected to be approximately 5% per year, and prices

will be increased in line with inflation. Wage and salary costs are
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 expected to increase by 7% per year, and all other costs (including rent) by
5% per year. No price or cost increases are expected in the first year of
production.

Corporate tax is at the rate of 35% payable in the year the profit occurs.
Assume that all sales and costs are on a cash basis and occur at the end of
the year, except for the initial purchase of machinery which would take
place immediately. No stocks will be held at the end of any year.

Required
(a) Produce a Discounted Cash Flow appraisal of the proposed project
and advise the company on the acceptability of the proposal.
Specify any assumptions you make.
(b) Briefly discuss the other major factors which should be given
further consideration, in order to enhance confidence in the
decision advice specified above, if this appraisal were to be carried
out as a practical exercise.
(c) Explain the importance in investment appraisal of the investing
firm having taxable profits. Indicate the effects which a lack of
taxable profits may have on investment decisions, and, briefly
comment on the main possibilities open to a firm to overcome such
effects.

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BOND VALUATION

Question 1

Consider two bonds, each with a $1,000 face value and each with three years
remaining to maturity.

(a) The first bond is a pure-discount bond that currently sells for $804.96.
What is its yield-to-maturity?

(b) The second bond currently sells for $775.40 and makes annual coupon
payments at a rate of 6% (that is, it pays $60 in interest per year). The
first interest payment is due one year from today. What is this bond’s
yield-to-maturity?

VALUATION OF EQUITY

Question 1

The price-earnings ratio for the RST Company is well above the average for the
stock market reflecting its market standing as a growth company. The earnings
performance of the company in recent years has not disappointed its shareholders.
Earnings have grown at an average rate of 20 per cent over the last five years.
While this has been partly the result of a high retention’s, the company has
consistently reinvested 80 per cent of its earnings, but the high profitability of
new investment has also played a role. Now competition is intensifying and the
rates of return on investments are expected to fall over the next few years.
Investments undertaken next year are expected to yield 22 per cent, the following
year 18 per cent, in year three 12 per cent, and by year four investments are
expected to generate no more than the rate of return required by shareholders of
10 per cent. Earnings next year are expected to be $6 million and the company is
expected to reinvest 80 per cent of earnings as in the past few years. After this
retention will be reduced as investment opportunities diminish: 60 per cent in
year two, 40 per cent in year three, and 20 per cent, which is expected to be the
average in the longer term, in year four.

a) What rate of return has the company been earning on its capital investment
programme in recent years?

b) What will the market value of the firm be at the end of the third year?

c) What is the firm’s price-earnings ratio based on its expected earnings next
year?

d) What proportion of the firm’s market value is accounted for by growth

opportunities?

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 e) Briefly discuss the critical assumptions underlying a valuation model
which you have employed in assessing the company’s market value.

Question 2

Blaney Engineering is a relatively small but profitable and expanding business.

During the coming year net earnings are expected to be $500,000. The company
is capable of continuing to generate this volume of net earnings every year, on the
basis of its existing business alone. However, the management intends investing
all next year’s earnings in additional projects that are expected to provide a
perpetual annual net yield of 16%. Furthermore, equally profitable additional
investments will be available for two more years after next year. Again it is
planned to retain all the firm’s earnings for investment in these years. In
subsequent years Blaney expects it will retain and invest only 50% of earnings
and that these additional investments will have a net yield of only 10% on
average.

The market’s required return on capital invested in this line of business is usually
around 10%.

a) Estimate the market value of the firm.

b) What proportion of this value is accounted by the value of the firm’s
investment opportunities (PVGO)?

c) What is the firm’s expected annual growth rate from the end of year 3
onwards.

d) Comment on the validity and usefulness of the constant growth of

dividends model.

Question 3

As a result of capital investment, stock market analysts expect post tax earnings
and dividends of UNIVO PLC to increase by 25% for two years and then revert to
the company’s existing growth rate which stands at 9.5%.

UNIVO’s systematic risk is estimated at 0.82, the risk free rate if 12%, and the
return on the market portfolio is 17%. The current market price of UNIVO’s
ordinary shares is $120, ex 1999 dividend, and the last dividend paid is $7 per
share.

Required

a) Using the dividend growth model estimate what a fundamental analyst

might consider being the intrinsic (or realistic) value of the company’s
shares. Comment upon the significance of your estimate for the
fundamental analyst.

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 Assume, for this part of the question only, that the cost of equity is not
expected to change. The cost of equity may be estimated by using the
CAPM.

b) If interest rates were to increase by 2% and expected dividend growth to

remain unchanged, estimate what affect this would be likely to have on the
intrinsic value of the company’s shares.

INTRODUCTION TO RISK AND RETURN

QUESTION 1

A share had a price of $2.50 at the start of the year, paid a dividend of 12 cents during the
year and had a price of $2.35 at the end of the year. What is the percentage return on the
share for the year?

QUESTION 2

You are faced with a choice of shares from among the three detailed below:

Market Return %
Condition Probability Share Share Share
A B C

Optimistic 0.25 16 4 20
Normal 0.50 12 6 14
Pessimistic 0.25 8 8 8

a) Calculate the expected return and standard deviation for each share.
b) Calculate the correlation coefficient and covariance between each pair of
investments.
c) Calculate the expected return and standard deviation of the two-and three- share
portfolios formed by combining together equal proportions of the shares.

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RISK-RETURN & CAPM

QUESTION 1

Mr Hartford estimates the risk of security A to be 20% (return per year) and the risk of
security B to be the same. He also believes their returns will be determined by
completely unrelated events (i.e. that their returns are uncorrelated).

(a) Assuming he is right, what will be the risk of a portfolio divided equally between
two securities?

(b) What about a portfolio with 60% invested in security A and 40% in B?

(c) What combination of the two securities is likely to have the smaller risk?

(d) Is the combination in (c) the one that Mr Hartford should choose?

QUESTION 2

A security analyst forecasts that each of three scenarios for the next year is equally likely:

(i) a boom,

(ii) controlled growth, and

(iii) a severe recession.

Under these three states of the world she projects returns on a specific security, the
market portfolio, and Treasury bills as shown in the table.

STATE OF THE WORLD

Optimistic Likely Pessimistic

(Boom) (Controlled Growth) (Recession)
------------------------------------------------------------------------------------------------------------
Probability of state 1 1 1
3 3 3
Return on market portfolio 20% 15% -5%
Return on Security A 25% 20% -10%
Return on Treasury bills 7% 7% 7%
------------------------------------------------------------------------------------------------------------

(a) What is the equation for the Capital Market Line?

(b) What would be the expected return and variance for a portfolio of which 50% is
invested in Treasury bills and 50% in the market portfolio?

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(c) What is the equation for the Security Market Line?

(d) Is the beta for security A such that you would consider the security aggressive or
defensive?

(e) What is the expected return on security A? What expected return would be
appropriate (based on the Security Market Line) for a security with the beta value
of security A?

QUESTION 3

Assume you can buy the market portfolio and borrow or lend at the risk free rate. The
market portfolio is expected to generate a return of 16% and the risk free rate is 8%. The
market portfolio has a standard deviation of return of 12%.

(a) Construct a portfolio offering a 10% return. How much risk does it carry?

(b) If you hope to achieve a 25% return what investment strategy should you pursue?
How much risk will you take on?

(c) If you plotted all the possible combinations of risk and expected return on a graph
what would it look like? What is it called?

QUESTION 4

The expected return on the market portfolio is 12%, with an accompanying standard
deviation of 4%. The risk free rate of interest is 5%. Place each of the portfolios

A RA = 19 σA = 8
B R B = 25 σB = 12
C RC = 16 σC = 6
D R D = 32 σD = 16
E R E = 22.5 σE = 10
F R F= 8 σF = 2

into one of the following categories: efficient, inefficient or super-efficient. In the case of
an inefficient portfolio state what the standard deviation should be for efficiency with the
given expected return.

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QUESTION 5

Two particular assets A and B are known to lie on the SML. A has a beta of 0.5 and
carries a risk premium of 4%. B has an expected return of 20% along with a beta of 1.75.
In the light of this information, determine whether the securities below are overpriced or
underpriced.

Security Expected Return % Beta

1 20 2.00
2 14 0.75
3 15 1.25
4 5 -0.25
5 31 3.25

COST OF DEBT & EQUITY AND WEIGHTED AVERAGE COST OF CAPITAL

1. The following information relates to Tyro Ltd, a manufacturing company (all

figures in $000):

Financial information for years ending 31 December

2009 2010 2011 2012 2013

Issued capital (share of $1) 2000 2000 4000 4000 4000

Reserves 2000 2500 800 1400 2100
10% non-redeemable debentures 1000 1000 1000 1000 1000
____ ____ ____ ____ ____

5000 5500 5800 6400 7100

____ ____ ____ ____ ____

Profit before tax 1080 1208 836 1478 1720

Taxation 3000 400 200 500 600
____ ____ ____ ____ ____

Profit after tax 780 808 636 978 1120

Dividends paid 280 308 336 378 410
____ ____ ____ ____ ____

Retentions 500 500 300 600 700

The current market value of the shares is $1.13 while the debentures are quoted at $62.50
per $100. Tyro’s equity beta has been calculated as 1.2 and the current risk-free rate is
12%. The rate of corporation tax throughout the period has been 50% and the basic rate
of income tax 30%. Tyro has consulted you on the cost of capital to be used in
appraising a major project in the same risk class as its existing business.

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Required

(a) Calculate the weighted-average cost of capital of Tyro Ltd.

(b) Calculate the required return on equity using the capital asset pricing model. You
can assume that the market risk premium is equal to 9%.

(c) Calculate an asset beta relevant to the project and use this to compute a project
cost of capital.

(d) Compare the results obtained and comment briefly on the different models used.

(You should state clearly any additional assumptions you make).

2. The directors of Red Sox PLC wish to calculate the cost of the company’s equity
capital for various decision-making purposes. To investigate the sensitivity of
their calculations, they have used two models, the (Gordon) dividend growth
model and the capital asset pricing model, to calculate the cost of equity capital. A
dividend of 10 cents per share has recently been paid by the company and the
current market price of the ordinary shares is $1 per share. Analysts have forecast
that the expected return on the stock market in the near future will be 0.15 (i.e.
15%) per annum with a standard deviation of return of 0.50 (i.e. 50%); the return
on a risk-free security is expected to be 0.05 (i.e. 5%) per annum. The covariance
of Red Sox’s returns with the market over the past five years has been estimated
as 0.25 on an annualized basis; the covariance is expected to rise to 0.275 in the
future owing to changes in the asset composition of the company. Dividend
growth rates, on an annual basis, for the past ten years have been as follows:

Years Dividend growth rate

2000-2004 5% per annum
2005 14% per annum
2006-2010 10% per annum

Let us assume that government controls restricted actual dividend growth to 5%

per annum between 2000 and 2004, but were lifted at the beginning of 2005. It is
generally believed to be highly unlikely that dividend controls will be
reintroduced in the foreseeable future.

(a) Estimate the cost of equity capital of Red Sox PLC using both the
Dividend constant growth model and the capital asset pricing model.
(b) Comment upon the results of your answer to (a).
(c) Discuss the likely impact of an increase in the rate of inflation upon a
company’s cost of equity capital.

3. Assume perfect markets except for corporate taxes at a rate of 50%. Roundstone
PLC is an all-equity company and has a cost of equity of 16%. The risk-free rate
is 10% and the expected market return is 15%. Roundstone’s management
decides to move to a capital structure such that debt-to-equity, in market-value
terms, will equal 0.5. At that level, debt in Roundstone is still considered risk
free.
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 (a) Estimate the cost of equity for Roundstone PLC in its revised capital
structure, explaining the reasons for the change in equity cost.

(b) Estimate the weighted-average cost of capital for Roundstone PLC and
explain the circumstances in which this would be appropriately used as a
discount rate for capital investment analysis.

(c) Briefly explain the practical problems which may be encountered when
calculating the market risk premium.

4. The Mariners Co. Ltd is soon to be incorporated. Its promoters are considering
five different possible capital structures for the new company. An analysis of
comparable companies with equivalent business risks has been undertaken. This
analysis shows that, if the before-tax cost of debt is constant at 10% irrespective
of the capital structure, then the cost of equity capital, after corporation tax, will
be as follows:

Gearing ratio Cost of equity capital

(Debt capital/total capital)
(%) (%)

0 20.000
20.0 21.250
40.0 23.333
50.0 25.000
60.0 27.500

The above predictions for the equity cost of capital also assume that the earnings
of the Mariners Co. Ltd. will be taxed at a rate of 50% and that the debt interest is
an allowable expense for tax purposes. The promoters expect that the company
will generate a steady annual earnings stream of $12.6 million, before the
payment of debt interest, for the foreseeable future.

(a) Calculate the effective after-tax weighted-average cost of capital and the
total market value for each of the five possible capital structures, assuming
that the before-tax annual cost of debt will be 10% (irrespective of the
capital structure chosen).

FOREIGN EXCHANGE RISK

Sebest Pte is concluding a £1,809,466 credit sale to the United Kingdom. The terms of
the sale are 180 days credit, payable in sterling. Foreign Exchange rates between
Singapore and £ Sterling have recently been volatile, and Sebest is considering taking
action in either the foreign exchange market, money market, or currency options market
to ensure its dollar receipts are close to S$4,625,000. The company expects the £ to
steadily depreciate in value during the next year by a total of 15% relative to the S$, but
due to uncertainties, particularly over the Euro and economic recession, the change in
exchange rate could range from a 5% appreciation in Sterling to a 30% depreciation

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(from a Singapore viewpoint). Assume it is now mid-September and that options
contracts expire at the end of the relevant month.

Foreign Exchange Market Rates

S$/£

Spot 2.5560 – 2.5620

1 month forward 2.5480 – 2.5540
3 months forward 2.5385 – 2.5420
6 months forward 2.5210 – 2.5270
1 year forward 2.5020 – 2.5080

Money Market Rates

Deposit Borrowing

6 months Singapore $ 3% 5%
6 months Sterling 5% 7.5%

Currency options (S$125,000 contracts) Option premia are cents per £

Exercise price S$ Calls Puts

Dec March Dec March

2.525 0.41 1.35 4.52 6.14

2.550 2.35 3.20 3.46 4.30
2.575 4.64 6.30 0.68 2.10

Required

a) Prepare a report illustrating how Sebest might safeguard its Singapore dollar
receipts, and recommend which course of action, if any, it should choose.

b) Discuss the relative importance of the management of translation exposure and

economic exposure to the multinational company.

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