CF – Past Exams Model Answers

08 Jun CF – Past Exams Model Answers

a) Kayak Plc is closing down its factory which will make all the workers redundant. Kayak’s CEO is enraged to learn that the firm must continue to pay for workers’ health insurance for 4 years. The cost per worker next year will be £2,400. The inflation rate is expected to be 4% per year and the health costs are expected to increase 3 percentage points faster than inflation. The nominal discount rate is 10%. What is the present value of this obligation? (8 marks)

b) You are to receive cash payments of £1,000 at the end of each of the next three years. Assuming a nominal discount rate of 7 percent, what is the present value of these cash flows? If the rate of inflation is 2 percent in years one and two and 3 percent in year 3, what are the values of these cash flows in real terms and what are the real discount rates for years one, two, and three? Show that discounting real cash flows using real discount rates gives the same present value as discounting nominal cash flows at a nominal discount rate. (9 marks)

c) A two-year and a five-year bond both have coupon rates of 7%. Both bonds are currently selling at par. How much does the price of each bond change if the interest rates fall to 5%? Explain the difference in the price change for these bonds? (8 marks)

Question 2

a) Rank the following alternatives in terms of present value assuming a discount rate of 8 percent.

(i) A growing perpetuity paying £25,000 each year, with the first payment in one year’s time. The growth rate of the perpetuity is 4 percent.

(ii) A four-year annuity paying £200,000 each year, with the first payment in one year’s time.

(iii) A payment of £750,000 in two years’ time.

(iv) A growing perpetuity paying £30,000 each year, with the first payment due immediately. The growth rate of the perpetuity is 3 percent.

(8 marks)

b) You are thinking of buying a fridge-freezer. Two competitive retailers, Dickson’s Plc and Flurry’s sell this machine with a price tag of £500. They have a buy now pay later scheme with Dickson’s Plc charging a flat interest rate of 9.4% with monthly compounding and Flurry’s Plc charging a rate of 9.2% with quarterly compounding. If you plan to repay in one year’s time, which retailer would you prefer to buy your machine from? What are the EARs charged by the two firms?

(9 marks)

c) A stock’s end-of-year price over a four year period is: 150p, 152p, 145p, and 180p. The dividend in each of the last three years, paid immediately before the date of the end-of-year price, is 8p. What are the returns on the stock in each of the last three years? What is the total return over the three years to an investor who buys the stock at 150p and holds the stock for three years, reinvesting intermediate dividends back into the stock? What is the equivalent constant annual average return over the three year period?

(8marks)

Question 3

Giving examples where possible, explain any three of the following

a) The direct and indirect costs of conducting an IPO

b) The typical succession of finance sources over the lifecycle of a business.

c) The long-term underperformance of IPOs and SEOs

d) The motives for companies to go private

(25marks)

Question 4

a) Over the past three years (Year 1 to Year 3) the stocks of two companies, ONE Plc and TWO Plc, generated annual returns to shareholders as follows:

i. For each of the three years (Year 1, Year 2, Year 3), calculate the annual return generated by a portfolio that is made up of the two stocks ONE and TWO with 80 percent of the portfolio invested in stock ONE and the rest in stock TWO.

(4 marks)

ii. Based on the annual portfolio returns, calculate the expected (average) portfolio return and the standard deviation of portfolio returns.

(4 marks)

iii. Can the standard deviation of the portfolio returns be approximated as the weighted average of the individual stock returns? Explain why or why not.

(4 marks)

b) Assuming the Capital Asset Pricing Model (CAPM) holds, calculate the expected returns and the risk premia of the following two portfolios.

1. Portfolio 1 has a beta of 1.5; the return on the market portfolio Rm is expected to be 8% and the riskfree rate Rf is 1%.

(2 marks)

2. Portfolio 2: the estimated correlation coefficient between the returns on Portfolio 2 and the market portfolio returns is 0.1, the standard deviation of the market portfolio returns is 3%, and the standard deviation of the returns of Portfolio 2 is 8%; the values of Rm and Rf are as for Portfolio 1.

(4 marks)

In each of parts (b1) – (b2), clearly show the derivation of your results.

(c) What is the security market line, and how has it been used in practice to quantify the equity cost of capital faced by a company?

(7 marks)

Question 5

a) Modigliani Inc. is a company that operates in a world with perfect capital markets (including no taxation). Its annual net operating income (NOI) is $1,000,000, and it is financed entirely by equity with a market value of 5 million.

The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E = 1.

Required:

i. Calculate the rate of return on equity given the present capital structure of the company (entirely equity-financed). Briefly explain your method and result.

(4 marks)

ii. Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) the company faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.

(7 marks)

iii. The company management approaches you for advice on its capital structure. Can you suggest an optimal capital structure that maximises the company value and minimises the cost of capital faced by the company?

(7 marks)

b) Explain why companies tend to prefer internal to external funds when financing profitable investment projects. Draw on existing theories and relevant empirical findings.

(7marks)

Question 6

a) Do companies follow a managed or a residual payout policy (in terms of their dividends and repurchases)?

(12.5 marks)

b) What possible link is there between payout policy (dividends and repurchases) and the agency conflict between corporate managers and shareholders? (12.5 marks)

 

Jun 2011

Question 1

c) Consider the following companies:

If the market capitalisation rate for each share is 8%, which company’s share is the most valuable?

(8 marks)

d) Tiger Plc’s shares are currently trading at 150 pence per share. Security analysts are forecasting a long-term earnings growth rate of 10%. The company has just paid a dividend of 3 pence per share.

i. Assume dividends are expected to grow along with earnings at 10% per year in perpetuity. What rate of return are investors expecting?

(3 marks)

ii. Tiger is expected to earn about 8% on book equity and to pay out 40% of earnings as dividends. Based on these forecasts, what is the growth rate of dividends? What is the rate of return that investors expect?

(6 marks)

e) On a bank loan, Bank A quotes you 12 percent compounded weekly, Bank B quotes you 12.1 percent compounded quarterly, while Bank C quotes you 12.25 percent compounded annually. Calculate these banks’ effective annual rates and comment on your answers.

(8 marks)

Question 2

a) Dolphin Industries is closing down an outmoded factory which will make all the workers redundant. Dolphin’s CEO is enraged to learn that the firm must continue to pay for workers’ health insurance for 4 years. The cost per worker next year will be £2,400. The inflation rate is expected to be 4% per year and the health costs are expected to increase 3 percentage points faster than inflation. The nominal discount rate is 10%. What is the present value of this obligation?

(8 marks)

b) A regional supermarket chain is deciding whether to install a fully automated bakery in each of its stores. Each bakery will cost £25,000 to install. Projected income per bakery is as follows

Why would the store continue to operate the bakery in years 4 and 5 if it produces no profits? What are the cash flows from investing in bakery? Assume each bakery is completely depreciated and has no salvage value at the end of its 5-year life.

(8 marks)

c) A 6 year government bond (with a face value of £100) makes annual coupon payments of 5% and offers a yield to maturity of 3% annually compounded. Suppose that one year from now the bond still yields 3%. If you buy the bond today and sell it after one year, what is the return on your investment over the 12 month period?

(9 marks)

Question 3

a) Discuss the various types of financing available for quoted and unquoted businesses.

(12 ½ marks)

b) What possible motives might companies have for going private?

(12 ½ marks)

Question 4

a) Over the past three years (Year 1 to Year 3) the stocks of two companies, First Plc and Second Plc, generated annual returns as follows:

i. For each of the three years (Year 1, Year 2, Year 3), calculate the annual return generated by a portfolio that is made up of the two stocks with 60 percent of the portfolio invested in First Plc and the rest in Second Plc.

ii. Based on the annual portfolio returns, calculate the expected (average) portfolio return and the standard deviation of portfolio returns.

(8 marks)

b) Assuming the Capital Asset Pricing Model (CAPM) holds, calculate the expected returns and the risk premia of the following three portfolios.

i. Portfolio 1 has a beta of 2; the return on the market portfolio Rm is expected to be 10% and the riskfree rate Rf is 2%.

(2 marks)

ii. Portfolio 2: the standard deviation of the market portfolio returns σm is 5 percent and the covariance between the market portfolio returns and the returns of Portfolio 2 σP2,m is 0.001; the values of Rm and Rf are as for Portfolio 1.

(4 marks)

iii. Portfolio 3: the estimated correlation coefficient between the returns on Portfolio 3 and the market portfolio returns is 0.7, and the standard deviation of the returns of Portfolio 3 is 2%; the values of σm, Rm and Rf are as for Portfolios 1 and 2.

(4 marks)

In each of parts (b1) – (b3), clearly show the derivations of your results.

c) What is the security market line, and how has it been used in practice to quantify the equity cost of capital faced by a company?

(7 marks)

Question 5

a) Consider a company that operates in a world with perfect capital markets (including no taxation), and is financed entirely by equity with a market value of $2.5 million. The annual net operating income (NOI) of the company is $500,000.

The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E = 1.

Required:

i. Calculate the rate of return on equity given the present capital structure (all equity). Briefly explain your method and result.

(4 marks)

ii. Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) it faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.

(7 marks)

iii. Suppose the company increased its ratio of debt to equity further. How do you expect its cost of debt, cost of equity, and its weighted average cost of capital to change?

(7 marks)

b) Explain and critically discuss whether the prospect of financial distress and its associated costs affect the financing decisions of companies in the real world.

(7 marks)

Question 6

a)

i. Explain the meaning of the terms “residual payout policy” and “managed payout policy”.

(5 marks)

ii. Does the empirical evidence suggest that U.S. and European companies follow a residual or a managed payout policy?

(10 marks)

b) Does payout policy affect firm value when there are differences in taxation between dividends and capital gains?

(10 marks)

 

Nov 2010

Question 1

The managers of MSAF Plc are considering the following projects (all values in £s)

Given the riskiness of these projects, investors require a 15% return on projects 1 and

2 and a 20% return on projects 3 and 4.

a) Calculate the payback period for each project and state what decision MSAF Plc will reach if they use a three-year payback period. (5 marks)

b) Calculate the IRRs for projects 1 and 4. What is the appropriate accept/reject decision for these two projects? (5 marks)

c) Calculate the NPV of each project. Which projects should MSAF Plc accept? (5 marks)

d) Discuss the implications of your answers in parts (a) and (c) (5 marks)

e) Discuss the implications of your results in parts (b) and (c) if projects 1 and 4 are mutually exclusive. (5 marks)

Question 2

a) You are thinking of buying a fridge-freezer. Two competitive retailers, Flurrys Plc and Power-House Plc sell this machine with a price tag of £500. They have a buy now pay later scheme with Flurrys Plc charging a flat interest rate of 9.4% with monthly compounding and Power-House Plc charging a rate of 9.2% with quarterly compounding. If you plan to repay in one year’s time, which retailer would you prefer to buy your machine from? What are the EARs charged by the two firms?

(9 marks)

b) You borrow £30,000 from a friend and agree that you will repay the loan by five equal end-of-year installments. Your friend will charge you a constant annual interest rate of 5%. What will be your annual repayments?

(8 marks)

c) A 6 year government bond (with a face value of £100) makes annual coupon payments of 5% and offers a yield to maturity of 3% annually compounded. Suppose that one year from now the bond still yields 3%. If you buy the bond today and sell it after one year, what is the return on your investment over the 12 month period?

(8 marks)

Question 3

Giving examples where possible, explain any threeof the following

a) Perfect capital markets and Fisher’s separation theorem

b) The payback period rule

c) Financial analysts’ valuation of companies

d) The long-term underperformance of IPOs and SEOs

(25 marks)

Question 4

a) Consider the stocks of Company A and Company B. For these stocks, you forecast the following returns (shown in the table below) depending on the state of the world. You expect that the three states of the world are equally likely.

i. For EACH of the two stocks separately, calculate its expected return and standard deviation.

(5 marks)

ii. To calculate the portfolio return, there are two possible methods.

1) Briefly outline BOTH possible methods (no need for actual calculations here). (5 marks)

2) Calculate the expected return and standard deviation of a portfolio invested equally in the two stocks using the method of your own choice (i.e. one of the two methods you outlined in part (1) above). (5 marks)

b) Suppose an investor is considering the following four stocks. The table below shows the expected returns and standard deviations of returns of the stocks.

Suppose the investor wants to invest all her wealth in just one single stock from the list of four stocks above. According to mean-variance analysis, how should the investor select the single stock? Briefly explain your answer.

[Note: You may wish to illustrate your answer with a graph of the share data. As you have no plotting paper available in the exam, there is no need to graph the share data accurately.] (5 marks)

c) Explain to the investor the advantages of investing in a broad portfolio that includes all four stocks in the table in part (b) above along with 20 other stocks from various industries. (5 marks)

Question 5

You are engaged as a consultant to advice a company, MDISPLC. Suppose you have data on four similar (or comparator) companies that operate in the same industry and are of similar size to MDIS. The data on the comparators’ capital structure and cost of finance are summarized in the table below:

You also have information on the expected market return (Rm) = 13%, and the risk free

interest rate (Rf) = 2%.

The company operates in a country with no corporate taxation and zero inflation.

a)

i. For EACH of the comparator companies that are similar to MDIS PLC (whose data are shown in the table above), find the cost of equity in terms of the required return on the stock of the company.

(4 marks)

ii. For EACH of the comparator companies that are similar to MDIS PLC (whose data are shown in the table above), calculate the weighted average cost of capital (WACC).

(4 marks)

b)

i. Find the asset value of the company using the no-growth discounted cash flow approach assuming

· MDIS’s latest annual cash flow (approximated by earnings before deducting interest) was £10 million per annum;

· annual cash flow can be assumed to remain constant for the indefinite future i.e., there is no reason to expect growth in cash flows;

· MDIS’s weighted average cost of capital WACC can be approximated by the average of the WACC of the similar (comparator) companies.

(5 marks)

ii. Given MDIS’s debt-equity ratio of 35/65, calculate the value of MDIS’s debt and equity.

(4 marks)

c) Suppose MDIS’s cost of debt is 12%, and its WACC is approximately the same as the average WACC of the comparator companies. Calculate MDIS’s

i. cost of equity (4 marks)

ii. and its equity beta. (4 marks)

Question 6

a) (a) Explain the role of payout policy in the context of the agency conflict between corporate managers and shareholders. (10 marks)

b)

i. Explain the meaning of the terms “residual payout policy” and “managed payout policy”. (5 marks)

ii. Does the empirical evidence suggest that U.S. and European companies follow a residual or a managed payout policy? (10 marks)