Ac3059 Za 2019

THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL
AC3059 ZA
BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN EDUCATION IN SOCIAL
SCIENCES
Financial Management
Wednesday 8 May 2019: 14.30 – 17.30
Time allowed: 3 hours
DO NOT TURN OVER UNTIL TOLD TO BEGIN
Candidates should answer FIVE of the following EIGHT questions: FOUR from
Section A and ONE from Section B. All questions carry equal marks.
Workings should be submitted for all questions requiring calculations. Any

necessary assumptions introduced in answering a question are to be stated.
8-column accounting paper is provided at the end of this question paper. If used, it
must be detached and fastened securely inside the answer book.
A calculator may be used when answering questions on this paper and it must
comply in all respects with the specification given with your Admission Notice. The
make and type of machine must be clearly stated on the front cover of the answer
book.
© University of London 2019
UL19/0069
Page 1 of 8
SECTION A
Answer four questions from this section.
1. Consider an all-equity firm whose only asset is the option to invest in one of two
mutually exclusive projects. Each project requires an investment today of
£400m. Next year, project A pays £520m with probability 80% and £200m with
probability 20%. Next year, project B pays £800m with probability 20% and
£200m with probability 80%. After these cash flows, the firm will be shut down.
There are no taxes, depreciation, or any other benefit or cost.
To implement one of these projects, the firm must raise debt financing. Note that
the managers of the firm act in the interest of the equity holders and that project
choice occurs after debt financing is granted, so debtholders cannot control
project choice after financing. However, debtholders can rationally anticipate the
actions of managers.
Assume that all cash-flows are discounted at 0%.
Required:
a) Compute the NPVs of the two projects. Which project is better?
[3 marks]
b) Show that the firm will be able to raise £400m today via the issue of debt
by offering to invest in project A. Compute the face value of the debt
required by lenders.
[5 marks]
c) Compute the NPVs of the two projects to the equity holders after debt
financing has been granted. Which project is the best one for equity
holders?
[4 marks]
d) Show that the firm will not be able to raise £400m today via the issue of
debt if debtholders are aware that project B is available for investment too.
[4 marks]
e) Using your answers to previous parts of the question, briefly comment on

the following statement: “Some firms may be excluded from debt markets,
i.e. there is no interest rate at which lenders are willing to lend to them”.
Which firms are most likely to be excluded?
[4 marks]
[Total 20 Marks]
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2. Answer all parts of this question.
a) Consider a two-period binomial setting. The current price of a stock is €80.

For each of the next two periods, the stock will either move up by 10% or
down by 10%. The risk-free rate per period is 5%. Assume that the stock
pays no dividend.
i) Using the risk-neutral method, price a two-period at-the-money

European put.
[8 marks]
ii) If the put option in part a) was American, would you wish to
exercise early? If so, how would this affect the option’s
premium?
[7 marks]
b) If an investor can construct a portfolio of stocks that has a long-run mean

return that is reliably above the mean return of the market, is this evidence
that the investor has some skill in picking stocks? Justify your answer.
[5 marks]
[Total 20 Marks]
3. Suppose company Alpha is considering a takeover of company Beta that is

deeply burdened with debt and is on the verge of bankruptcy. Alpha
generates perpetual free cash flow of US$ 10m per year and the required
return on equity is 5%. In addition to the free cash flow, Alpha has US$ 50m
of cash inside the company. Alpha is all equity financed, with 10m shares.
Beta has 90% market leverage ratio and 1m shares currently traded at
US$ 15 per share. The takeover will improve the value of Beta's assets by
10%. Assume that shareholders of Alpha and Beta will equally share the
gain in this takeover.
Required:
a) What is the market value of Beta's assets without a takeover? What is the
price that Alpha pays for Beta's total equity?
[5 marks]
b) Suppose Alpha uses cash in the corporate account to take over Beta's
existing shares. How much should Alpha pay for each share of Beta? What is
the capital structure of the merged company? What is the share price of the
post-takeover Alpha?
[7 marks]
Question continues on the next page
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Page 3 of 8
c) Suppose Alpha issues equity to compensate Beta's shareholders. How many
shares of Alpha per one share of Beta should be issued to Beta's
shareholders? What is the ownership structure and capital structure of the
merged company?
[8 marks]
[Total 20 Marks]
4. Silkroad is a family business and wholesaler, importing silk fabric from Far
Eastern countries, and selling on to specialist curtain and upholstery retailers.
During the year ended 31 December 2018 the business entered into a new
contract with local branches of a national retail chain. The business also
expanded its warehouse and automated its office processes in the year.
Summarized financial statements for 2018 and 2017 for the business are as
follows:
The financial statements are on the next page
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Page 4 of 8
Income statements for the years ended 31 December
2018 2017
£ £ £ £
Revenue 382,100 289,800
Cost of sales (275,150) (194,170)
Gross profit 106,950 95,630
Administrative expenses 45,235 44,240

Distribution costs 16,430 14,680
Interest 1,875 -
(63,540) (58,920)
Profit before tax 43,410 36,710
Taxation (13,023) (11,013)
Profit for the year 30,387 25,697
Statements of financial position at 31 December
2018 2017
£ £ £ £
Non-current assets 130,000 78,750
Current assets
Inventories 24,650 15,600
Accounts receivable 22,850 11,275
Bank and cash 3,750 11,700
51,250 38,575
Total assets 181,250 117,325
Capital 77,760 73,350

Non-current liabilities
5% bank loan,
repayable 2020 50,000 -
Current liabilities
Account payable 53,490 43,975
Total capital and
liabilities 181,250 117,325
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Page 5 of 8
Required:
a) Calculate the following ratios for Silkroad for the financial years ended 31
December 2018 and 2017:
i. Return on Equity;
ii. Return on Capital Employed;
iii. Net profit Margin;
iv. Gross Profit Margin;
v. Administrative Expenses as a Percentage of Revenue;
vi. Distribution Costs as a Percentage of Revenue;
vii. Asset Turnover;
viii. Leverage.
[15 marks]
b) Using both the summarized financial statements and the ratios from part 1),
produce a report that provides an analysis of the financial performance of
Silkroad for the year ended 31 December 2018 in comparison with the previous
year.
[5 marks]
[Total 20 Marks]
5. The Running for Life Centre is considering replacing its treadmills and is faced
with a choice between two models: the Track model costing £800 per
machine and the Pro model costing £1,400 per machine. The Pro model is
sturdier and the cost of maintenance per machine is £50 per year. The Track
model is less robust and requires more maintenance costing £75 per machine
per year. The Track model is also less durable. The Running for Life Centre
estimates that it would need to replace the Track machines after 3 years of
use and that it would need to buy 30 machines to ensure that enough are
working at any particular time. The Pro model would last 4 years and only 25
machines would be needed. All other revenue and costs for the Running for
Life Centre would remain the same. The required discount rate for this project
is 10%.
Required:
a) On the basis of the information provided, which machine should the Running
for Life Centre buy? Explain.
[15 marks]
b) What other information would you consider before taking a decision?

[5 marks]
[Total 20 Marks]
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Page 6 of 8
6. Answer all parts of this question.
a) The stock of DRAM PLC is currently selling for £20 per share. Earnings per
share in the coming year are expected to be £3.50. The company, whose
capital structure consists solely of equity, has a policy of paying out 25% of
its earnings each year in dividends. The remaining part is retained and
invested in projects that earn a 5% internal rate of return per year. This
situation is expected to continue indefinitely.
i) Show that the growth rate g in earnings that is consistent with a pay-out ratio
PYT and return on equity ROE is g = (1 – PYT)*ROE.
[5 marks]
ii) Assuming the current market price of the stock reflects its intrinsic value as
computed using the constant-growth Dividend Discount Model, what rate of
return do DRAM’s investors require?
[5 marks]
iii) By how much would DRAM’s stock price change if all its earnings were paid
as dividends and nothing was reinvested?
[5 marks]
b) Clearstream has made the decision to invest in a new project with a high
positive NPV. Before the investment decision has been announced to the
public, a director of Clearstream however buys shares under an assumed
name and makes an enormous profit by selling them just after the new
investment is eventually disclosed to the world but before the project
generates any cash flow. What do these facts tell us about the efficiency of
this stock market?
[5 marks]
[Total 20 Marks]
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SECTION B
Answer one question from this section.
7. Describe the components of a company’s working capital. Discuss whether

each of these components should be managed separately and differently,
unlike the views of some authors who believe that they should all be jointly
minimised.
[Total 20 Marks]
8. Give your views and reasons as to whether or not the London or New York
stock markets will ever become completely ‘semi-strong’ efficient as defined
by the efficient market hypothesis.
[Total 20 Marks]
END OF PAPER
UL19/0069
Page 8 of 8
Examiners’ commentaries 2019

AC3059 Financial management
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of the course and having completed the essential reading and activities, you should be
able to:
• describe how different financial markets function

• estimate the value of different financial instruments (including stocks and bonds)
• make capital budgeting decisions under both certainty and uncertainty
• apply the capital assets pricing model in practical scenarios
• discuss the capital structure theory and dividend policy of a firm
• estimate the value of derivatives and advise management how to use derivatives in risk
management and capital budgeting
• describe and assess how companies manage working capital and short-term financing
• discuss the main motives and implications of mergers and acquisitions
• integrate subject matter studied on related modules and to demonstrate the
multi-disciplinary aspect of practical financial management problems
• use academic theory and research to question established financial theories
• be more proficient in researching materials on the internet and Online Library
• use excel for statistical analysis.
1
Format of the examination
The examination is three hours long, during which you should answer five questions from a selection
of eight. The paper has two sections, A and B, with six questions in Section A and two in Section B.
Candidates should answer four questions from Section A and one from Section B. All questions carry
equal marks.
Section A has the analytical and computational questions that test your ability to apply analytical
and computational skills to the problems set, and then they usually conclude with a part requiring
interpretation of the solutions prepared in the first part(s) of the question. The questions in Section
B usually require a mix of understanding, knowledge, description or analysis and application applied
to the theory, concept or practical scenario presented. The answer should then be presented in an
essay format, unless otherwise requested.
Workings should be submitted for all questions requiring calculations. Any necessary assumptions
introduced in answering a question are to be stated.
Approach to questions set and format of the answers given
The problem-based questions in Section A are quite lengthy and to speed up your understanding
and analysis of what each question is about, we suggest that first you go to the end of each question
and read the requirements for that question before reading the text in the body of the question.
This approach saves you time that otherwise would have been spent reading information for a
question that you are not going to attempt, since you can decide whether or not to attempt a
question once you have read its requirements. If you are not going to attempt a particular question,
then you have not wasted time reading information that you do not need to read.
The second benefit is that, having read the requirements for a question you are going to attempt,
you can then go on and read the whole question with an idea of what information you expect to be
looking for in order to answer the question set.
Wherever a written answer is required, be it a whole answer or just part of the answer, you will be
expected to produce an answer which presents and develops the theory(ies) and concept(s) that are
appropriate, and then to sustain your argument in the context of the question set. If a judgement is
required, then it should be demonstrated in light of the argument you have presented for the context
given to you. The length of your answer should reflect the maximum marks that can be awarded to
your answer. Do not write page after page to answer a question that is only worth, say, five marks
maximum, since you should not spend more than nine minutes on such an answer. If you have spent
more time on the five-mark answer, you are reducing the time you could spend earning marks
elsewhere. Remember that spending more than a quarter of the examination time on one or more
questions can seriously reduce your chances on the other question(s) you want to tackle.
Read widely
You are expected to read beyond the subject guide and the additional material, and any insights you
gain should be included in your answers. For example, you could go beyond the textbook and
subject guide material on the efficient markets hypothesis and read a wide range of articles on
various research studies on semi-strong and weak form markets. You will then have the material you
need to answer a question on efficient markets.
Answer forms
In the answers to the computational questions you should include your workings. Partial credit
cannot be awarded if the final numbers presented are wrong through errors of omission, calculation
2
etc. unless your workings are shown.
In the essay-type questions, you should structure your answers, starting with an introductory
paragraph that outlines the answer you will be giving and the arguments you will be making. In the
main body of your answer, describe the theories and concepts that provide the basis of the argument
that can then be developed and substantiated. The concluding section should draw together the
main points of your argument in a summary.
Key steps to improvement

• Read beyond the subject guide.
• Practise computational questions in the subject guide, textbooks and any other appropriate
sources.
• Practise both computational and written questions from past examination papers. As the
examination draws closer, practise under time pressure, remembering that you probably
only have approximately 36 minutes per question in which to write your answer.
• Ensure your written answers to your practice questions do attempt to answer the questions
posed and not the one you wish you could be answering. Learn to focus on the contents,
context and requirements of that specific question.
Readings for this paper
Please note that shorthand will be used when referring to the following textbooks:
• BMA – Brealey, R.A., S.C. Myers and F. Allen, Principles of corporate finance. (New York:
McGraw–Hill Inc, 2010) tenth edition [ISBN 9780071314268].
• SG – subject guide. Fung, L. Financial management. (London: University of London
International Programmes, 2015).
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
3

Important note

references
section.
Comments on specific questions – Zone A
Candidates should answer FIVE of the following EIGHT questions: FOUR from Section A and
ONE from Section B. All questions carry equal marks.
Section A
Question 1
Consider an all-equity firm whose only asset is the option to invest in one of two
mutually exclusive projects. Each project requires an investment today of £400m.
Next year, project A pays £520m with probability 80% and £200m with probability
20%. Next year, project B pays £800m with probability 20% and £200m with
probability 80%. After these cash flows, the firm will be shut down. There are no
taxes, depreciation, or any other benefit or cost.
To implement one of these projects, the firm must raise debt financing. Note that
the managers of the firm act in the interest of the equity holders and that project
choice occurs after debt financing is granted, so debtholders cannot control project
choice after financing. However, debtholders can rationally anticipate the actions of
managers.
Assume that all cash-flows are discounted at 0%.
4
Required:
(a) Compute the NPVs of the two projects. Which project is better?
(3 marks)
(b) Show that the firm will be able to raise £400m today via the issue of debt by
offering to invest in project A. Compute the face value of the debt required by
lenders.
(5 marks)
(c) Compute the NPVs of the two projects to the equity holders after debt
financing has been granted. Which project is the best one for equity holders?
(4 marks)
(d) Show that the firm will not be able to raise £400m today via the issue of debt if
debtholders are aware that project B is available for investment too.
(4 marks)
(e) Using your answers to previous parts of the question, briefly comment on the
following statement: ‘Some firms may be excluded from debt markets, i.e. there
is no interest rate at which lenders are willing to lend to them’. Which firms are
most likely to be excluded?
(4 marks)
(Total 20 marks)
Reading for this question
BMA, Chapters 17 and 18.
SG, Chapter 12.
Approaching the question
This question addresses issues related to agency problems associated with the use of debt. It
illustrates the asset substitution problem in a simple setting with two mutually exclusive projects
generating different cash-flows in two possible states of nature.
Consider any project presented to debtholders and assume that debtholders believe that the firm
will indeed invest in this project. In order to derive the face value of debt which the firm
promises to reimburse, one has to recognise that, in a competitive borrowing market, the
proceeds from borrowing have to be equal to the present value of the repayments. Given this face
value of debt, one then has to check whether managers acting in the interest of the equity holders
do not prefer to invest subsequently in the other project by computing and comparing the NPVs
to equity holders associated with each project.
(a) NPVA = −£400m + (80% × £520m + 20% × £200m) = £56m.

NPVB = −£400m + (20% × £800m + 80% × £200m) = −£80m.
Therefore, Project A is the only project to have a positive NPV. It is also the least risky one.
(b) Assume that project A is presented to the debtholders. Let us denote the face value of debt
by F . In a competitive borrowing market, the amount lent is equal to the present value of
the repayments. If F is lower than or equal to £520m, it then follows that:
80% × F + 20% × £200m = £400m.
Equivalently:
£400m − 20% × £200m
F = = £450m.
80%
As F is lower than £520m, the firm will hence be able to raise £400m today via an issue of
debt by offering to invest in project A.
5
(c) Assume now that financing has been granted. The NPVs to equity holders for each project
are:
NPVE
A = 80% × £70m = £56m
NPVE
B = 20% × £350m = £70m.
Once financing has been granted, equityholders would prefer to invest in project B as
opposed to project A advertised to the debtholders. Managers of the firm acting in the
interest of the equity holders will hence invest in project B.
(d) The lenders will assume that project B will be selected and, if F < £800m, the face value of
debt required is such that:
20% × F + 80% × £200m = £400m.
Equivalently:
£400m − 80% × £200m
F = = £1,200m
20%
which exceeds £800m. Furthermore:
20% × £800m + 80% × £200m = £320m < £400m.
Project B hence cannot be financed either via debt.

(e) Finance would be available if:
• the payoff in the bad state was close to the amount borrowed
• the firm could credibly commit to investing in project A.
Firms are excluded from financing if:
• their sets of project choices are hard to assess a priori
• they have projects with low payoffs in the bad state relative to their financing needs
• they cannot credibly commit to investing in a given project
• they cannot raise enough equity.
Question 2
Answer all parts of this question.
(a) Consider a two-period binomial setting. The current price of a stock is e80. For
each of the next two periods, the stock will either move up by 10% or down by
10%. The risk-free rate per period is 5%. Assume that the stock pays no
dividend.
i. Using the risk-neutral method, price a two-period at-the-money European
put.
(8 marks)
ii. If the put option in part i. was American, would you wish to exercise early?
If so, how would this affect the option’s premium?
(7 marks)
(b) If an investor can construct a portfolio of stocks that has a long-run mean
return that is reliably above the mean return of the market, is this evidence
that the investor has some skill in picking stocks? Justify your answer.
(5 marks)
(Total 20 marks)
6
For (a):
SG, Chapter 19.
For (b):
SG, Chapters 7 and 8.
This part of the question addresses issues related to the pricing of and exercising of put options.
The easiest way to solve the question is to use the risk-neutral method. The current stock price
must be equal to the present value of the stock prices obtaining in the upper and lower nodes at
the end of the period which enables you to derive the quasi probabilities of seeing up and down
moves. As the European put option can only be exercised at the end of the two periods, one first
derives the payoffs from the put option at each node at the end of the second period and then
prices the put option as the present value of these payoffs using the risk-free rate. The American
put option can be exercised at the end of the first period which means that you should check at
both nodes whether or not it pays to exercise it at that date.
(a) i. Using the risk-neutral method, the current price of the stock must be equal to the
present value of the stock prices obtaining in the upper and lower nodes at the end of the
period, with the discount rate used being the risk-free rate. It hence follows that:
S[q(1 + u) + (1 − q)(1 − d)]
S= .
1 + rF
Equivalently:
d + rF 15%
q= = = 75%.
d+u 20%
Given that the European put option is priced at-the-money, it follows that the exercise
price X is equal to the current stock price. Furthermore, it only pays to exercise the
European put option at the end of the two periods if the stock price is below the exercise
price.
SDD = S(1 − d)2 = e80 × 0.81 = e64.8 < X
SU D = SDU = S(1 + u)(1 − d) = e80 × 1.1 × 0.9 = e79.2 < X
SU U = S(1 + u)2 = e80 × 1.21 = e96.8 > X.
It hence follows that:

2q(1 − q)(X − SU D ) + (1 − q)2(X − SDD )
p=
(1 + rF )2
(2 × 0.75 × 0.25 × e0.8) + (0.252 × e15.2)
=
(1.05)2
= e1.13
ii. The American put option can be exercised at the end of the first period if it pays to do
so. At the end of the first period:
SD = S(1 − d) = e80 × 0.9 = e72 < X
SU = S(1 + u) = e80 × 1.1 = e88 > X.
7
At best, it hence pays to exercise the put option in the down node. By exercising the
option at this node, the payoff will be:
X − SD = e8.
By not exercising the put option at this node, the present value of the expected payoff
will be:
q(X − SDU ) + (1 − q)(X − SDD ) 0.75 × e0.8 + 0.25 × e15.2
= = e4.19.
1 + rF 1.05
It hence pays to exercise this American put option in the down node at the end of the
first period.
Therefore, the price of the American put option must strictly exceed the price of the
European put option.
(b) This part of the question addresses issues related to portfolio performance measurement and
market efficiency. The statement made is wrong. It is more likely that the portfolio is riskier
than the market. Hence the need to use risk-adjusted performance measures.
Question 3
Suppose company Alpha is considering a takeover of company Beta that is deeply

burdened with debt and is on the verge of bankruptcy. Alpha generates perpetual
free cash flow of US$ 10m per year and the required return on equity is 5%. In
addition to the free cash flow, Alpha has US$ 50m of cash inside the company.
Alpha is all equity financed, with 10m shares. Beta has 90% market leverage ratio
and 1m shares currently traded at US$ 15 per share. The takeover will improve the
value of Beta’s assets by 10%. Assume that shareholders of Alpha and Beta will
equally share the gain in this takeover.
Required:
(a) What is the market value of Beta’s assets without a takeover? What is the price
that Alpha pays for Beta’s total equity?
(5 marks)
(b) Suppose Alpha uses cash in the corporate account to take over Beta’s existing
shares. How much should Alpha pay for each share of Beta? What is the capital
structure of the merged company? What is the share price of the post-takeover
Alpha?
(7 marks)
(c) Suppose Alpha issues equity to compensate Beta’s shareholders. How many
shares of Alpha per one share of Beta should be issued to Beta’s shareholders?
What is the ownership structure and capital structure of the merged company?
(8 marks)
(Total 20 marks)
(a) With respect to Beta:

VDB VDB
= = 90%
VAB VDB + VEB
with VEB = 1m × $15 = $15m.
It follows that:
VDB = 9 × VEB = $135m and VAB = VDB + VEB = $150m.
8
The gain, G, in Beta’s asset value expected from the takeover is:
10% × VAB = $15m.
Given that Alpha and Beta equally share the gain from the takeover, Alpha pays Beta’s
shareholders:
G
VEB + = $15m + $7.5m = $22.5m.
2
(b) Given that there are 1m shares in Beta, Alpha should offer $22.5 per share. The asset value
of the combined firm post-merger is:
$10m
VAC = VAA + VAB + G = + ($50m − $22.5m) + $150m + $15m = $392.5m
5%
VDC = $135.0m
VDC $135.0m
LEV C = C
= = 34.4%
VA $392.5m
VEC = $257.5m
$257.5m
P = = $25.7.
10m
(c) Assuming that equity is used to pay Beta’s shareholders, the asset value of the combined
firm post-merger is:
$10m
VAC = VAA + VAB + G = + $50m + $150m + $15m = $415m
5%
VEC = VAC − VDC = $280m
VDC $135.0m
LEV C = C
= = 32.5%.
VA $415.0m
Beta’s shareholders hence get $22.5m/$280m = 8.04% of the equity in the combined firm. If
N denotes the number of shares to be issued, then:
N
= 8.04%.
N + 10m
This implies that:

8.04%
N= × 10m = 0.874m.
91.96%
Shareholders in Beta hence get 0.0874 shares in the combined firm per share in Beta.
Question 4
Silkroad is a family business and wholesaler, importing silk fabric from Far Eastern
countries, and selling on to specialist curtain and upholstery retailers. During the
year ended 31 December 2018 the business entered into a new contract with local
branches of a national retail chain. The business also expanded its warehouse and
automated its office processes in the year.
Summarised financial statements for 2018 and 2017 for the business are as follows:
9
Required:
(a) Calculate the following ratios for Silkroad for the financial years ended 31
December 2018 and 2017:
i. Return on Equity
ii. Return on Capital Employed
iii. Net profit Margin
iv. Gross Profit Margin
10
v. Administrative Expenses as a Percentage of Revenue

vi. Distribution Costs as a Percentage of Revenue
vii. Asset Turnover
viii. Leverage.
(15 marks)
(b) Using both the summarised financial statements and the ratios from part (a),
produce a report that provides an analysis of the financial performance of
Silkroad for the year ended 31 December 2018 in comparison with the previous
year.
(5 marks)
(Total 20 marks)
BMA, Chapter 17.
SG, Chapter 28.
This question addresses issues related to financial analysis and performance evaluation.
Candidates were expected to derive a number of financial ratios and comment on their evolutions
over two consecutive years. A possible approach would be to start by explaining changes in
returns on equity through changes in leverage and changes in returns on capital employed. The
latter change can then be explained by changes in margins, asset turnover, and leverage.
(a) The required ratios are as follows:

Ratio Suggested working 2018 2017
Return on Equity net income / equity 39.1% 35.0%
Return on Capital Employed operating profit / long-term capital × 100 35.4% 50.0%
Net Profit Margin profit after tax / turnover × 100 8.0% 8.9%
Gross Profit Margin gross profit / turnover × 100 28.0% 33.0%
Administrative Expenses % administrative expenses / turnover × 100 11.8% 15.3%
Distribution Costs % distribution costs / turnover × 100 4.3% 5.1%
Asset Turnover sales / total assets 2.11 2.47
Leverage debt over equity 64.3% 0.0%
(b) ROE looks high, and increases from 35% to 39% are due entirely to increased leverage.
ROCE declines because of the increase in debt-financed capital? Gross profit margin and
net profit margin are down: is the company accepting lower margins in return for growth in
revenue? Or not managing costs as carefully as before? Both administrative expenses and
distribution costs as a proportion of revenue are coming down. Asset turnover is decreasing:
is the increase in assets not yet reflected in the commensurate increase in sales?
Question 5
The Running for Life Centre is considering replacing its treadmills and is faced with
a choice between two models: the Track model costing £800 per machine and the
Pro model costing £1,400 per machine. The Pro model is sturdier and the cost of
maintenance per machine is £50 per year. The Track model is less robust and
requires more maintenance costing £75 per machine per year. The Track model is
also less durable. The Running for Life Centre estimates that it would need to
replace the Track machines after 3 years of use and that it would need to buy 30
11
machines to ensure that enough are working at any particular time. The Pro model
would last 4 years and only 25 machines would be needed. All other revenue and
costs for the Running for Life Centre would remain the same. The required discount
rate for this project is 10%.
Required:
(a) On the basis of the information provided, which machine should the Running
for Life Centre buy? Explain.
(15 marks)
(b) What other information would you consider before taking a decision?
(5 marks)
(Total 20 marks)
This question addresses issues related to project appraisal. One has to invest in one of two
possible types of treadmills with different estimated lives. One could thus calculate the present
value of costs associated with each option over a period of time at the end of which both types of
treadmills have to be replaced. The shortest period of time is 12 years. This is tedious though.
Alternatively, one could calculate the equivalent annual cost over the estimated life of the
treadmills for each option and select the option with the lowest equivalent annual cost.
(a) The approach used here consists in calculating the equivalent annual cost (EAC) per
treadmill defined as the annual cost, excluding the investment cost, for which the present
value over the treadmill’s life is equal to the present value of all costs, including the
investment cost, over the treadmill’s life. One then multiplies this equivalent annual cost per
treadmill by the number of treadmills required for each option and selects the option with
the lowest equivalent annual cost. On this basis, one should hence invest in the Track option.
Track Model Years

Per Machine (£) 0 1 2 3
Cost 800 Cost per year 800 75 75 75
Maintenance Cost 75 PV of Cost per Year 800 68.2 62.0 56.3
Economic Life 3 PV 986.5
Quantity 30 EAC 396.7
Discount Rate 10%
EAC per Year 11900.8
Pro Model Years

Per Machine (£) 0 1 2 3 4
Cost 1400 Cost per Year 1400 50 50 50 50
Maintenance Cost 50 PV of Costs per Year 1400 45.5 41.3 37.6 34.2
Economic Life 4 PV 1558.5
Quantity 25 EAC 491.7
Discount Rate 10%
EAC per Year 12291.5
12
(b) Other considerations include:

• the quality of the experience for the treadmills’ users
• removal costs
• how likely it is that treadmills can be replaced at the same cost
• the rate of innovation associated with treadmills
• the floor space required by each option
• the opportunity cost associated with the use of floor space.
Question 6
Answer all parts of this question.
(a) The stock of DRAM PLC is currently selling for £20 per share. Earnings per
share in the coming year are expected to be £3.50. The company, whose capital
structure consists solely of equity, has a policy of paying out 25% of its earnings
each year in dividends. The remaining part is retained and invested in projects
that earn a 5% internal rate of return per year. This situation is expected to
continue indefinitely.
i. Show that the growth rate g in earnings that is consistent with a pay-out
ratio PYT and return on equity ROE is g = (1 − P Y T ) × ROE.
(5 marks)
ii. Assuming the current market price of the stock reflects its intrinsic value as
return do DRAM’s investors require?
(5 marks)
iii. By how much would DRAM’s stock price change if all its earnings were paid
as dividends and nothing was reinvested?
(5 marks)
(b) Clearstream has made the decision to invest in a new project with a high
positive NPV. Before the investment decision has been announced to the public,
a director of Clearstream however buys shares under an assumed name and
makes an enormous profit by selling them just after the new investment is
eventually disclosed to the world but before the project generates any cash flow.
What do these facts tell us about the efficiency of this stock market?
(5 marks)
(Total 20 marks)
For (a):
BMA, Chapter 4.
SG, Chapter 15.
For (b):
BMA, Chapter 13.
SG, Chapter 8.
13
(a) This question addresses issues related to dividend policy, investments, and valuation. It
illustrates how investments financed through decreases in payout ratios affect valuations of
stocks.
Intuitively, the change in earnings comes from the earnings not paid out and invested at the
return on equity. Given a constant dividend payout ratio, the growth rate in dividends must
be equal to the growth rate in earnings. The price of a stock is then equal to next year’s
dividend per share divided by the difference between the cost of equity capital and the
growth rate in dividends. This formula can then be used to solve this question.
i. It is always the case that:
N It+1 = N It + ROE × (1 − P Y T ) × N It
where N It denotes net income (earnings) generated at date t.

DIVt+1 − DIVt N It+1 − N It
g= = = ROE × (1 − P Y T ).
DIVt N It
ii. As EP St+1 = £3.50, it follows that:
DIVPS t+1 = P Y T × EP St+1 = 25% × £3.50 = £0.875
where DIV P St and EP St , respectively, denote dividend per share and earnings per
share at date t.
DIVPS t+1
Pt = .
rE − g
Equivalently:
DIVPS t+1 £0.875

rE = +g = + (5% × 75%) = 8.125%.
Pt £20
iii. We have:
DIVPS t+1 EP St+1 £3.5
Pt = = = = £43.07.
rE rE 8.125%
It follows that the price increases by £43.07 − £20 = £23.07.
The reason for this increase is that earnings are reinvested at a ROE which is lower than
the cost of equity capital.
(b) This question addresses issues related to market efficiency. The fact that a director of
Clearstream buys shares under an assumed name and makes an enormous profit by selling
them just after the new investment is eventually disclosed is consistent with capital markets
being inefficient in the strong form and efficient in the semi-strong form.
Section B
Question 7
Describe the components of a company’s working capital. Discuss whether each of

these components should be managed separately and differently, unlike the views of
some authors who believe that they should all be jointly minimised.
(Total 20 marks)
14
BMA, Chapter 30.
SG, Chapter 18.
This question addresses issues related to working capital management. Candidates were expected
to provide insights into inventory management, trade receivables management, and trade
payables management. Candidates were then expected to provide arguments for managing these
components independently and arguments for coordinating their management.
Managing each of the components of a company’s working capital separately and differently may
not maximise working capital turnover. In contrast, jointly minimising components of working
capital maximises working capital turnover. It may, however, not maximise the value of a
company’s equity or enterprise value. A given business strategy may lead to a higher working
capital turnover, a lower profit margin, and a lower ROE.
Question 8
Give your views and reasons as to whether or not the London or New York stock
markets will ever become completely ‘semi-strong’ efficient as defined by the
efficient market hypothesis.
(Total 20 marks)
BMA, Chapter 13.
SG, Chapter 8.
This question addresses issues related to market efficiency. Candidates were encouraged to define
semi-strong market efficiency, provide evidence on semi-strong market efficiency, and explain
Grossman and Stiglitz paradox. If markets were informationally efficient, stock prices would
instantaneously reflect new information. Therefore, there would be no reason for anyone to
collect and process any information as there would be no way to make any profit from these
activities. However, if no-one collects and processes any information, how can markets be
efficient in the first place? It follows that markets cannot be fully efficient. Candidates could also
claim that it is impossible to prove whether or not capital markets are efficient and provide
supporting arguments.
Many candidates discussed all forms of market efficiency. These efforts were not rewarded as the
question focused on semi-strong market efficiency.
15

Important note

references
section.
Comments on specific questions – Zone B
Candidates should answer FIVE of the following EIGHT questions: FOUR from Section A and
ONE from Section B. All questions carry equal marks.
Section A
Question 1
The Fitness Centre is considering replacing its treadmills and is faced with a choice
between two models: the Track1 model costing £900 per machine and the
ProFitness model costing £1,400 per machine. The ProFitness model is sturdier and
the cost of maintenance per machine is £50 per year. The Track1 model is less
robust and requires more maintenance costing £70 per machine per year. The
Track1 model is also less durable. The Fitness Centre estimates that it would need
to replace the Track1 machines after 3 years of use and that it would need to buy 30
machines to ensure that enough are working at any particular time. The ProFitness
model would last 4 years and only 25 machines would be needed. All other revenue
and costs for the Fitness Centre would remain the same. The required discount rate
for this project is 10%.
16
Required:
(a) On the basis of the information provided, which machine should the Fitness
Centre buy? Explain.
(15 marks)
(b) What other information would you consider before taking a decision?
(5 marks)
(Total 20 marks)
This question addresses issues related to project appraisal. One has to invest in one of two
possible types of treadmills with different estimated lives. One could hence calculate the present
value of costs associated with each option over a period of time at the end of which both types of
treadmills have to be replaced. The shortest period of time is 12 years. This is tedious though.
Alternatively, one could calculate the equivalent annual cost over the estimated life of the
treadmills for each option and select the option with the lowest equivalent annual cost.
(a) The approach used here consists in calculating the equivalent annual cost (EAC) per
treadmill defined as the annual cost, excluding the investment cost, for which the present
value over the treadmill’s life is equal to the present value of all costs, including the
investment cost, over the treadmill’s life. One then multiplies this equivalent annual cost per
treadmill by the number of treadmills required for each option and selects the option with
the lowest equivalent annual cost. On this basis, one should hence invest in the ProFitness
option.
17
(b) Other considerations include:

• the quality of the experience for the treadmills’ users
• removal costs
• how likely it is that treadmills can be replaced at the same cost
• the rate of innovation associated with treadmills
• the floor space required by each option
• the opportunity cost associated with the use of floor space.
Question 2
Rally is an all-equity firm with assets worth $25 billion and 10 billion shares
outstanding. Rally plans to borrow $10 billion and use these funds to repurchase
shares. The firm’s corporate tax rate is 35%, and Rally plans to keep its
outstanding debt equal to $10 billion permanently.
Required:
(a) Without the increase in leverage, what would Rally’s share price be?
(2 marks)
(b) Suppose Rally offers $2.75 per share to repurchase its shares. Would
shareholders sell for this price?
(6 marks)
(c) Suppose Rally offers $3.00 per share, and shareholders tender their shares at
this price. What will Rally’s share price be after the repurchase?
(6 marks)
(d) What is the lowest price Rally can offer and have shareholders tender their
shares? What will its stock price be after the share repurchase in that case?
(6 marks)
(Total 20 marks)
This question addresses issues related to capital structure in a Modigliani–Miller setting with
corporate taxes. It investigates the impact of stock repurchases financed by issues of debt, that
is, decreases in leverage, on a firm’s intrinsic value of equity and intrinsic share price. Candidates
are asked whether equity holders will tender their shares given the terms of various repurchase
offers before deriving the lowest offer equityholders will accept.
In order to answer these questions, candidates have to derive the firm’s intrinsic value of equity
and intrinsic share price following the borrowing and before the planned repurchase of shares.
You may hence recognise that the value of the firm’s equity pre repurchase is equal to the value
of the unlevered firm’s equity (value of the firm’s equity before the issue of debt) plus the present
value of the tax shields associated with the new debt. Dividing this value by the existing number
of shares generates the intrinsic post borrowing pre repurchase share price. Shareholders should
only tender their shares if the price offered by the firm to buy their shares weakly exceeds this
intrinsic price.
18
(a) The share price is $25bn/$10bn, that is, $2.5.

(b) Candidates may use one of the following methods:
Method I:
Just before the share repurchase:
VA = $25bn (Existing Assets) + $10bn (Cash) + $3.5bn (PV of Tax Shield)

= $38.5bn
VEL = VA − VD = $38.5bn − $10bn = $28.5bn.
Therefore, the intrinsic share price is $28.5bn/10bn, that is, $2.85.

Method II:
Just before the share repurchase:
VEL = VEU + PV of Tax Shields = $25bn + $3.5bn = $28.5bn.
Therefore, the intrinsic share price is $28.5bn/10bn, that is, $2.85.

Regardless of the method selected, shareholders will not sell for $2.75 per share because the
share’s average price is $2.85.
(c) Following the share repurchase:
Method I:
VA = $25bn (Existing Assets) + $3.5bn (PV of Tax Shield)

= $28.5bn
VEL = VA − VD = $28.5bn − $10bn = $18.5bn.
The number N of shares is 10bn − ($10bn/3bn), that is, 6.667bn.

The share price increases to:
VEL $18.5bn
= = $2.775.
N 6.667bn
Method II:
VEL = VEU + PV of Tax Shields = ($25bn − $10bn) + $3.5bn = $18.5bn.
The number N of shares is 10bn − ($10bn/3bn), that is, 6.667bn.

The share price increases to:
VEL $18.5bn
= = $2.775.
N 6.667bn
(d) From part (b), the fair value of the shares prior to repurchase is $2.85. At this price, Rally
will have 10bn − ($10bn/$2.85) = 6.491bn shares outstanding, which will be worth
$18.5bn/6.491bn = $2.85 per share after the repurchase. Therefore, shareholders will be
willing to sell at this price.
Question 3
The stock of DRAM PLC is currently selling for £20 per share. Earnings per share
in the coming year are expected to be £3.50. The company, whose capital structure
consists solely of equity, has a policy of paying out 25% of its earnings each year in
dividends. The remaining part is retained and invested in projects that earn a 5%
internal rate of return per year. This situation is expected to continue indefinitely.
19
(a) Show that the growth rate g in earnings that is consistent with a payout ratio
PYT and return on equity ROE is g = (1 − P Y T ) × ROE.
(5 marks)
(b) Assuming the current market price of the stock reflects its intrinsic value as
return do DRAM’s investors require? Explain.
(5 marks)
(c) By how much would DRAM’s stock price change if all its earnings were paid as
dividends and nothing was reinvested? Explain.
(5 marks)
(d) If the company were to increase its dividend payout ratio to 40%, what would
happen to its stock price?
(5 marks)
(Total 20 marks)
BMA, Chapter 4.
SG, Chapter 15.
This question addresses issues related to dividend policy, investments, and valuation. It
illustrates how investments financed through decreases in payout ratios affect valuations of stocks.
Intuitively, the change in earnings comes from the earnings not paid out and invested at the
return on equity. Given a constant dividend payout ratio, the growth rate in dividends must be
equal to the growth rate in earnings. The price of a stock is then equal to next year’s dividend
per share divided by the difference between the cost of equity capital and the growth rate in
dividends. This formula can then be used to solve this question.
(a) It is always the case that:
N It+1 = N It + ROE × (1 − P Y T ) × N It
where N It denotes net income (earnings) generated at date t.

DIVt+1 − DIVt N It+1 − N It
g= = = ROE × (1 − P Y T ).
DIVt N It
(b) As EP St+1 = £3.50, it follows that:
DIVPS t+1 = P Y T × EP St+1 = 25% × £3.50 = £0.875
where DIV P St and EP St , respectively, denote dividend per share and earnings per share
at date t.
DIVPS t+1
Pt = .
rE − g
Equivalently:
DIVPS t+1 £0.875
rE = +g = + (5% × 75%) = 8.125%.
Pt £20
20
(c) We have:
DIVPS t+1 EP St+1 £3.5
Pt = = = = £43.07.
rE rE 8.125%
It follows that the price increases by £43.07 − £20 = £23.07. The reason for this increase is
that earnings are reinvested at a ROE which is lower than the cost of equity capital.
(d) With PYT = 40%, then:
g = ROE × (1 − P Y T ) = 5% × (1 − 40%) = 3%.

DIVt+1 P Y T × EP St+1 40% × £3.5
Pt = = = = £17.76.
rE − g rE − ROE × (1 − P Y T ) 8.125% − 3%
The question did not ask for any numerical derivation. So full marks were provided to candidates
explaining that the stock price would decrease as earnings were reinvested at a ROE which was
lower than the cost of equity capital.
Question 4
The following financial information relates to the financial position and performance
of Eagle Plc, a UK-domiciled financial investment group, for the year to 31 July
2018 and 2017.
21
Required:
(a) Calculate (to two decimal points) the following ratios for Eagle plc for both
2018 and 2017:
i. Return On Equity
ii. Return On Capital Employed
iii. Net Margin
iv. Current Ratio
v. Fixed Asset Turnover
22
vi. Current Asset Turnover

vii. Leverage
viii. Price/Earnings Ratio.
(15 marks)
(b) Using your answers to part (a), evaluate the financial performance and position
of Eagle plc, focusing on the concerns of shareholders, managers and
debtholders.
(5 marks)
(Total 20 marks)
BMA, Chapter 17.
SG, Chapter 28.
This question addresses issues related to financial analysis and performance evaluation.
Candidates were expected to derive a number of financial ratios and comment on their evolutions
over two consecutive years. A possible approach would be to start by explaining changes in
returns on equity through changes in leverage and changes in returns on capital employed. The
latter change can then be explained by changes in margins, asset turnover, and leverage.
(a) The required ratios are as follows:
Ratio Suggested working 2018 2017

Return on Equity profit after tax/shareholders’ funds × 100 53.58% 75.09%
Return on Capital Employed operating profit / net assets × 100 59.00% 82.34%
Net Profit Margin profit after tax / turnover × 100 16.88% 27.72%
Current Ratio current assets / current liabilities 1.55 1.47
Fixed Asset turnover turnover / fixed assets 4.46 times 3.50 times
Current Asset turnover turnover / current assets 2.66 times 2.88 times
or
turnover / net current assets 7.5 times 9.05 times
Leverage debt over equity 7.4 13.7
P/E ratio share price / EPS 7.81 8.00
(b) PAT decreased as a result of a large increase on COS. ROE decreased as both ROCE and
leverage decreased. The fact that leverage decreased is good news for debtholders. ROCE
decreased mainly as NM decreased (impact of a rise in COS) and CAT decreased (there was
an increase in FAT though). The PE ratio decreased in spite of a likely reduction in the cost
of equity capital reflecting lower leverage most likely because investors now expect lower
growth as reflected by the dividend cut.
Question 5
Suppose you are the sole owner of company Taurus plc. The market value of your
company is £100m and there are 20m shares outstanding. Now you are thinking
about acquiring the target company Gemini with a stand-alone market value of
£50m with 25m shares outstanding.
Assume first that the present value of the synergies generated by combining the two
companies is £20m.
23
Required:
(a) Suppose you issue new shares to pay Gemini’s shareholders so that the net cost
of the acquisition to Taurus is nil, meaning the shareholders of Gemini break
even. How many shares do you need to issue? How many shares do you need to
pay for each share in Gemini?
(6 marks)
Assume from now on instead that the present value of the synergies generated by
combining the two companies is −£10m as opposed to £20m.
(b) Redo part (a) with the new present value of synergies. Would you choose to
acquire company Gemini? Discuss your findings in comparison with those
reported in part (a).
(4 marks)
Assume now that you hold only 2m shares in Taurus but have control rights in the
company (meaning that you can decide on Taurus’ acquisition of Gemini). In
addition, assume that you also have 15m shares in Gemini.
(c) What is the value of your portfolio without any acquisition?

(2 marks)
(d) Suppose you have the opportunity to have company Taurus acquire company
Gemini by offering 1 newly created share of Taurus for two shares of Gemini.
What is the post-merger share price after the acquisition? What is your payoff ?
Do you proceed with the proposed merger?
(6 marks)
(e) Based on your findings in (c) and (d), discuss how ownership structure
(especially ownership in the target company) affects acquirers’ tendency to take
over targets with negative synergy.
(2 marks)
(Total 20 marks)
SG, Chapter 28.
This question addresses issues related to mergers and acquisitions.
In the first part of the question, candidates were expected to recognise that the net cost of an
acquisition is the intrinsic value of the equity stake in the combined firm given to equity holders
in the target firm minus the market value of target’s firm equity. Assuming that capital markets
are efficient, the intrinsic value of the combined firm’s equity stake is the sum of the market
values of the acquiring and target firms and the present value of the synergies. Setting the net
cost of the acquisition cost to zero then allows for the derivation of the equity stake to be
provided to the equity holders of the target firm.
In the second part of the question, candidates were expected to decide whether Taurus should
acquire Gemini by using a specified share offer recognising that they already had shares in both
Taurus and Gemini. In order to take this decision, students should compare the value of their
portfolio of shares consisting of Taurus and Gemini shares in the absence of the proposed
acquisition with the value of their portfolio of shares in the combined company if the acquisition
takes place.
24
(a) We have:
VCF = (£100m + £50m) + £20m = £170m.
The value of the new shares, K, must be equal to £70m: the sum of the market value of
Gemini’s equity, £50m, and the present value of the synergies, £20m. Hence the number of
new shares to be issued and the post-acquisition share price, P , must satisfy the following
equations:
N × P = K and (N + 20m) × P = VCF .
K + 20m × P = VCF .
Equivalently:
VCF − K K £70m
P = = £5 and N = = = 14m.
20m P £5
(b) Taurus would offer £40m worth in shares in the combined firm for shares in Gemini which
are worth £50m. The shareholders of Gemini would reject this offer.
(c) Without the acquisition, you are worth:
2m
× £100m = £10m (Taurus)
20m
15m
× £50m = £30m (Gemini)
25m
(d) The number of new shares to be issued, N , is equal to 25m/2 = 12.5m.

The post-acquisition share price will hence be equal to:
VCF £140m
= = £4.31.
N + 20m 32.5m
With the acquisition, you are hence worth:

15m
2m + × £4.31 = £40.92m.
2
which strictly exceeds your worth in the absence of an acquisition:
£40m.
You would hence proceed with the acquisition.

(e) Controlling shareholders in the acquiring company may benefit from an acquisition with
negative synergies a long as they own a larger stake in the target company and offer a
premium to the shareholders of the target company.
Question 6
Consider a company which has $10m to invest into one of three projects with the
following cash-flows generated next year in the good and bad states of nature, with
p denoting the probability of a given state obtaining for any project:
25
For simplicity, there is no time discount.
Required:
(a) Assume that the firm is purely equity financed. How does the firm rank the
three projects?
(3 marks)
(b) Suppose the firm carries debt maturing in the next year with face value $10m.
How do equityholders rank the three projects? How do debtholders rank the
three projects?
(7 marks)
(c) Rank the three projects again if the face value of debt is $1m.
(5 marks)
(d) What is the risk shifting problem? Comparing your findings in parts (a) and
(b), briefly discuss the relation between risk shifting and the face value of debt.
(3 marks)
(e) How does the debt overhang problem differ from the risk shifting problem?
(2 marks)
(Total 20 marks)
SG, Chapter 12.
This question addresses issues related to agency problems associated with the use of debt. It
illustrates the risk-shifting problem in a simple setting with three mutually exclusive projects
generating different cash-flows in two possible states of nature. It illustrates how the occurrence
of risk-shifting decreases in the face value of debt.
In order to rank the three projects, the recommended approach is to derive NPVs of projects to
the relevant claimholders or values of the relevant financial claims associated with different
projects. As it is assumed that no time discounting is taking place, the value of any financial
claim associated with any project is equal to the expected pay-off to that particular class of
claimholders.
(a) Assuming that the firm is purely equity finance, the NPVs of the three projects to the firm
are as follows:
N P VP 1 = −$10m + (0.2 × $40m) = −$2m
N P VP 2 = −$10m + 0.5 × ($12m + $10m) = +$1m
N P VP 3 = −$10m + (0.4 × $15m + 0.6 × $8m) = +$0.8m.

The project rankings in decreasing order of attractiveness are hence: P2, P3 and P1.
(b) Assuming now that the firm has $10m of debt maturing at the end of the year, the NPVs of
the three projects to the firm’s equityholders are as follows:
VPE1 = 0.2 × $30m = $6m
VPE2 = 0.5 × $2m = $1m
VPE3 = 0.4 × $5m = $2m.
26
The project rankings in decreasing order of attractiveness to equityholders are hence: P1,
P3 and P2.
In contrast, the NPVs of the three projects to the firm’s debtholders are as follows:
VPD1 = 0.2 × $10m = $2m
VPD2 = 0.5 × ($10m + $10m) = $10m
VPD3 = 0.4 × $10m + 0.6 × $8m = $8.8m.
The project rankings in decreasing order of attractiveness to debtholders are hence: P2, P3
and P1.
(c) Assuming now that the firm has only $1m of debt maturing at the end of the year, the
NPVs of the three projects to the firm’s equityholders are as follows:
VPE1 = 0.2 × $39m = $7.8m
VPE2 = 0.5 × ($11m + $9m) = $10m
VPE3 = 0.4 × $14m + 0.6 × $7m = $9.8m.
The project rankings in decreasing order of attractiveness to equityholders are hence: P2,
P3 and P1.
The NPVs of the three projects to the firm’s debtholders are as follows:
VPD1 = 0.2 × $1m = $0.2m
VPD2 = 0.5 × ($1m + $1m) = $1m
VPD3 = 0.4 × $1m + 0.6 × $1m = $1m.
The project rankings in decreasing order of attractiveness to debtholders are hence: P2, P3
and P1.
(d) The risk shifting problem arises in highly levered firms when managers working on behalf of
shareholders find it incentive compatible to invest in lower NPV and higher risk projects as
shareholders only get pay-offs in the higher states of nature. The occurrence of risk shifting
decreases in the face value of debt.
(e) The debt overhang occurs in highly levered firms when managers working on behalf of
shareholders find it incentive compatible to not invest in positive NPV projects as
shareholders have to commit funds to take these projects but only get pay-offs in the higher
states of nature.
Section B
Question 7
‘The senior managers and the Board of Directors do not need to worry about the
dividend policy of their organisations, since it is not relevant to firms’ value.’
Evaluate this statement with references to two schools of thought regarding
dividend policy.
(Total 20 marks)
27
BMA, Chapter 16.
SG, Chapter 13.
This question addresses issues related to dividend policy. Candidates may wish to go through
Modigliani and Miller’s dividend irrelevancy argument which supports the statement and then go
through one of the theories disagreeing with the statement. The latter argument include,
signaling effects, agency costs effects, and clientele effects. Candidates should also provide
empirical evidence to support their conclusions.
Question 8
Give your views and reasons as to whether or not the London or Hong Kong stock
markets will ever become completely ‘semi-strong’ efficient as defined by the
efficient market hypothesis.
(Total 20 marks)
BMA, Chapter 13.
SG, Chapter 8.
This question addresses issues related to market efficiency. Candidates were encouraged to define
semi-strong market efficiency, provide evidence on semi-strong market efficiency, and explain
Grossman and Stiglitz paradox. If markets were informationally efficient, stock prices would
instantaneously reflect new information. Therefore, there would be no reason for anyone to
collect and process any information as there would be no way to make any profit from these
activities. However, if no-one collects and processes any information, how can markets be
efficient in the first place? It follows that markets cannot be fully efficient. Candidates could also
claim that it is impossible to prove whether or not capital markets are efficient and provide
supporting arguments.
Many candidates discussed all forms of market efficiency. These efforts were not rewarded as the
question focused on semi-strong market efficiency.
28
THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL
AC3059 ZB
BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN EDUCATION IN SOCIAL
SCIENCES
Financial Management
Wednesday 8 May 2019: 14.30 – 17.30
Time allowed: 3 hours
DO NOT TURN OVER UNTIL TOLD TO BEGIN
Candidates should answer FIVE of the following EIGHT questions: FOUR from
Section A and ONE from Section B. All questions carry equal marks.
Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.
8-column accounting paper is provided at the end of this question paper. If used, it
must be detached and fastened securely inside the answer book.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
© University of London 2019
UL19/0070
Page 1 of 8
SECTION A
1. The Fitness Centre is considering replacing its treadmills and is faced with a
choice between two models: the Track1 model costing £900 per machine and
the ProFitness model costing £1,400 per machine. The ProFitness model is
sturdier and the cost of maintenance per machine is £50 per year. The Track1
model is less robust and requires more maintenance costing £70 per machine
per year. The Track1 model is also less durable. The Fitness Centre
estimates that it would need to replace the Track1 machines after 3 years of
use and that it would need to buy 30 machines to ensure that enough are
working at any particular time. The ProFitness model would last 4 years and
only 25 machines would be needed. All other revenue and costs for the
Fitness Centre would remain the same. The required discount rate for this
project is 10%.
Required:
a) On the basis of the information provided, which machine should the
Fitness Centre buy? Explain.
[15 marks]
b) What other information would you consider before taking a decision?

[5 marks]
[Total 20 Marks]
2. Rally is an all-equity firm with assets worth $25 billion and 10 billion shares
outstanding. Rally plans to borrow $10 billion and use these funds to
repurchase shares. The firm’s corporate tax rate is 35%, and Rally plans to
keep its outstanding debt equal to $10 billion permanently.
Required:
a) Without the increase in leverage, what would Rally’s share price be?
[2 marks]
b) Suppose Rally offers $2.75 per share to repurchase its shares. Would
shareholders sell for this price?
[6 marks]
c) Suppose Rally offers $3.00 per share, and shareholders tender their
shares at this price. What will Rally’s share price be after the repurchase?
[6 marks]
UL19/0070
Page 2 of 8
d) What is the lowest price Rally can offer and have shareholders tender their
shares? What will its stock price be after the share repurchase in that
case?
[6 marks]
[Total 20 Marks]
3. The stock of DRAM PLC is currently selling for £20 per share. Earnings per
share in the coming year are expected to be £3.50. The company, whose
capital structure consists solely of equity, has a policy of paying out 25% of its
earnings each year in dividends. The remaining part is retained and invested in
projects that earn a 5% internal rate of return per year. This situation is expected
to continue indefinitely.
a) Show that the growth rate g in earnings that is consistent with a payout ratio
PYT and return on equity ROE is g = (1 – PYT)*ROE.
[5 marks]
b) Assuming the current market price of the stock reflects its intrinsic value as
return do DRAM’s investors require? Explain.
[5 marks]
c) By how much would DRAM’s stock price change if all its earnings were paid
as dividends and nothing was reinvested? Explain.
[5 marks]
d) If the company were to increase its dividend payout ratio to 40%, what would
happen to its stock price?
[5 marks]
[Total 20 Marks]
UL19/0070
Page 3 of 8
4. The following financial information relates to the financial position and
performance of Eagle Plc, a UK-domiciled financial investment group, for the
year to 31 July 2018 and 2017:
Income Statement for

year to 31 July
£’m £’m
2018 2017
Turnover 2500.0 2260.0
Cost of sales 1500.0 1130.0
Gross profit 1000.0 1130.0
Distribution costs 280.0 224.3
Administrative expenses 192.5 168.6
Operating profit 527.5 737.1
Tax 105.5 110.6
Profit after Tax 422.0 626.5
Financial statement continues on the next page
UL19/0070
Page 4 of 8
Balance Sheet as at 31 July £’m £’m
2018 2017
Non-Current assets
Property, plant & equipment 489.0 555.2
Intangible assets 53.3 65.4
Other financial assets 18.2 25.0
560.5 645.6
Current assets
Inventories 315.0 282.5
Receivables 375.0 339.0
Cash at cash equivalents 248.5 162.3
Current liabilities
Trade payables 562.5 503.4
Accruals 42.5 30.8
605.0 534.2
Non-Current Liabilities
Borrowings 106.4 60.8
787.6 834.4
Share capital and reserves
Share capital 365.6 207.9
Retained profit 422.0 626.5
Total Shareholder's funds 787.6 834.4
Additional Information 2018 2017

EPS £3.20 £2.50
Share price £25.00 £20.00
Dividend per share £0.70 £1.00
UL19/0070
Page 5 of 8
Requred:
a) Calculate (to two decimal points) the following ratios for Eagle plc for both
2018 and 2017:
i. Return On Equity;
ii. Return On Capital Employed;
iii. Net Margin;
iv. Current Ratio;
v. Fixed Asset Turnover;
vi. Current Asset Turnover;
vii. Leverage;
viii. Price/Earnings Ratio.
[15 marks]
b) Using your answers to part 1), evaluate the financial performance and position
of Eagle plc, focusing on the concerns of shareholders, managers and debt
holders.
[5 marks]
[Total 20 Marks]
5. Suppose you are the sole owner of company Taurus plc. The market value of
your company is £100m and there are 20m shares outstanding. Now you are
thinking about acquiring the target company Gemini with a stand-alone market
value of £50m with 25m shares outstanding.
Assume first that the present value of the synergies generated by combining
the two companies is £20m.
Required:
a) Suppose you issue new shares to pay Gemini’s shareholders so that the
net cost of the acquisition to Taurus is nil, meaning the shareholders of
Gemini break even. How many shares do you need to issue? How many
shares do you need to pay for each share in Gemini?
[6 marks]
Assume from now on instead that the present value of the synergies
generated by combining the two companies is -£10m as opposed to
£20m.
b) Redo part 1) with the new present value of synergies. Would you choose
to acquire company Gemini? Discuss your findings in comparison with
those reported in part 1).
[4 marks]
UL19/0070
Page 6 of 8
Assume now that you hold only 2m shares in Taurus but have control rights in
the company (meaning that you can decide on Taurus’ acquisition of Gemini).
In addition, assume that you also have 15m shares in Gemini.
c) What is the value of your portfolio without any acquisition?
[2 marks]
d) Suppose you have the opportunity to have company Taurus acquire
company Gemini by offering 1 newly created share of Taurus for two
shares of Gemini. What is the post-merger share price after the
acquisition? What is your payoff? Do you proceed with the proposed
merger?
[6 marks]
e) Based on your findings in 3) and 4), discuss how ownership structure

(especially ownership in the target company) affects acquirers’ tendency to
take over targets with negative synergy.
[2 marks]
[Total 20 Marks]
6. Consider a company which has $10m to invest into one of three projects with
the following cash-flows generated next year in the good and bad states of
nature, with p denoting the probability of a given state obtaining for any
project:
Project 1 Project 2 Project 3

Cash-Flow p Cash-Flow p Cash-Flow p
$m % $m % $m %
Good 40 20 12 50 15 40
Bad 0 80 10 50 8 60
For simplicity, there is no time discount.
Required:
a) Assume that the firm is purely equity financed. How does the firm rank the
three projects?
[3 marks]
b) Suppose the firm carries debt maturing in the next year with face value $10m.
How do equity holders rank the three projects? How do debt holders rank the
three projects?
[7 marks]
UL19/0070
Page 7 of 8
c) Rank the three projects again if the face value of debt is $1m.
[5 marks]
d) What is the risk shifting problem? Comparing your findings in parts 1) and 2),
briefly discuss the relation between risk shifting and the face value of debt.
[3 marks]
e) How does the debt overhang problem differ from the risk shifting problem?
[2 marks]
[Total 20 Marks]
SECTION B
7. ‘The senior managers and the Board of Directors do not need to worry about
the dividend policy of their organizations, since it is not relevant to firms’
value.’ Evaluate this statement with references to two schools of thought
regarding dividend policy.
[Total 20 Marks]
8. Give your views and reasons as to whether or not the London or Hong-Kong
stock markets will ever become completely ‘semi-strong’ efficient as defined
by the efficient market hypothesis.
[Total 20 Marks]
END OF PAPER
UL19/0070
Page 8 of 8

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THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

Wednesday 8 May 2019: 14.30 – 17.30

Time allowed: 3 hours

DO NOT TURN OVER UNTIL TOLD TO BEGIN

Workings should be submitted for all questions requiring calculations. Any

© University of London 2019

Assume that all cash-flows are discounted at 0%.

e) Using your answers to previous parts of the question, briefly comment on

a) Consider a two-period binomial setting. The current price of a stock is €80.

i) Using the risk-neutral method, price a two-period at-the-money

b) If an investor can construct a portfolio of stocks that has a long-run mean

3. Suppose company Alpha is considering a takeover of company Beta that is

The financial statements are on the next page

Administrative expenses 45,235 44,240

Statements of financial position at 31 December

Capital 77,760 73,350

b) What other information would you consider before taking a decision?

7. Describe the components of a company’s working capital. Discuss whether

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

• describe how different financial markets function

Format of the examination

Approach to questions set and format of the answers given

etc. unless your workings are shown.

Key steps to improvement

Readings for this paper

Examination revision strategy

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

Answer four questions from this section.

Assume that all cash-flows are discounted at 0%.

Reading for this question

BMA, Chapters 17 and 18.

SG, Chapter 12.

Approaching the question

(a) NPVA = −£400m + (80% × £520m + 20% × £200m) = £56m.

80% × F + 20% × £200m = £400m.

20% × F + 80% × £200m = £400m.

20% × £800m + 80% × £200m = £320m < £400m.

Project B hence cannot be financed either via debt.

Answer all parts of this question.

Reading for this question

BMA, Chapters 20 and 21.

SG, Chapter 19.

BMA, Chapters 8 and 13.

SG, Chapters 7 and 8.

Approaching the question

SDD = S(1 − d)2 = e80 × 0.81 = e64.8 < X

SU D = SDU = S(1 + u)(1 − d) = e80 × 1.1 × 0.9 = e79.2 < X

SU U = S(1 + u)2 = e80 × 1.21 = e96.8 > X.

It hence follows that:

SD = S(1 − d) = e80 × 0.9 = e72 < X

SU = S(1 + u) = e80 × 1.1 = e88 > X.

Suppose company Alpha is considering a takeover of company Beta that is deeply

Approaching the question

(a) With respect to Beta:

VDB = 9 × VEB = $135m and VAB = VDB + VEB = $150m.