You are on page 1of 35

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON AC3059 ZA


(279 0059)

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Financial Management

Thursday, 10 May 2012 : 10.00am to 1.00pm

Candidates should answer FOUR of the following NINE questions: TWO from Section A,
ONE from Section B and ONE further question from either section. 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.

Extracts from compound interest tables are given at the end of Section A of this paper.

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 2012


UL12/0005 PLEASE TURN OVER
D01 Page 1 of 5
SECTION A

Answer TWO questions from this section and not more than one further question. (You are reminded that
four questions in total are to be attempted with at least one from Section B.)

1. Dreyers Grand Ice Cream Holdings Inc. is a publicly-held US company that has two primary
businesses: ice cream manufacturing and ice cream distribution. Dreyers assets have a total market
value of $180m of which 70% are manufacturing assets and 30% are distribution assets. The beta for
manufacturing assets is 0.47. Dreyers equity beta is 0.75. Dreyers only liability is $20m of long-
term debt with a beta of 0.3. The current share price is $22.86 and there are 7m shares outstanding.

Required:
(a) What is Dreyers overall asset beta? (6 marks)

(b) Dreyers is considering selling the distribution assets and investing the proceeds in short-term
government bonds. If Dreyers goes through with this, would the firms equity beta increase,
decrease, or stay the same? (4 marks)

(c) Redden Microbatch Ice Cream Inc., a privately held firm, markets and sells super premium ice
cream. Unlike Dreyers, Redden Microbatch does not manufacture its own ice cream. Redden
Microbatch will go through an IPO this week. If you were to value Redden Microbatch, explain
which discount rate you would use in order to calculate the present value of future free cash
flows to all claimholders. Assume that the market risk premium is 8.4%. (6 marks)

(d) Redden Microbatch has a capital structure consisting of 25% debt and 75% of equity. Its debt
has a beta of 0.35. If you were to value Redden Microbatchs equity, explain which discount
rate you would use in order to calculate the present value of dividends? (6 marks)

(e) During the road show for institutional investors, the founders of Redden Microbatch indicated
that the companys hurdle rate was 25%. How does this particular information influence your
opinion of the company? (3 marks)

2. Consider a strategic (i.e. value-enhancing) merger/takeover between two firms A and B. Firm A has
100,000 shares outstanding priced at $2 each, and firm B 200,000 shares priced at $1 each. If a
merger takes place, the new firm could make cost savings in production and marketing of $4,000 each
year indefinitely. The cost of capital is 10%.

Required:
(a) Suppose firm A proposes a bid for firm Bs shares worth $1.2 each, and also suppose the bid is
going to be accepted for sure by all of Bs shareholders. Work out the price-response to the bid
announcement by a rational market which takes the announcement as a complete surprise. Do
you think firm A is overpaying for firm Bs shares? Explain your answer. (8 marks)

(b) Suppose now that the two firms have agreed to a merger where each share in firm A will be
converted into 2 shares in the merged firm, and each share in firm B will be converted into 1
share in the merged firm. Work out the price-response to the announcement of the merger,
making similar assumptions as in (a). (9 marks)

(c) What mechanisms do companies adopt in an effort to prevent takeovers? Given that the targets
shareholders typically benefit from a takeover, can these takeover defences ever be justified?
(8 marks)

UL12/0005
D01 Page 2 of 5
3. Visual-Audio Systems (VAS) Ltd is a video production company and currently rents the building in
which its production equipment is located at an annual cost of 150,000, including all service charges.

The company is considering purchasing an alternative building in which to undertake its video
business. These alternative premises are due to be demolished by the local council in 4 years time, to
make way for a new road and it is known that the council will purchase the building at that time for
100,000. Because of the instability caused by the council's plans, VAS can purchase the building at a
knock-down price of 250,000. Otherwise, since the building is located in a prime residential area, the
land on which the building stands would be worth 1.8 million. Currently the building is in a state of
disrepair, but a structural survey which has already been undertaken by VAS costing 3,000,
recommends that the building must be upgraded at a cost of 50,000 before VAS moves in.

The annual heating and lighting expenses on the new building will be 40,000, but VAS will save the
annual rents on its current premises. The removal costs of moving its equipment into the new
building, and the cost of moving out again in five years time will be 25,000 on each occasion.

VAS pays corporation tax on its profits at 30%, and the tax authorities allows VAS to offset its
corporate tax liabilities by using straight line depreciation on its fixed assets. You may assume that
VAS has sufficient taxable profits to take full advantage of any tax shields from purchasing the
building. VAS applies an opportunity cost of capital of 10 per cent to all future cash flows. Assume
all annual cash-flows occur at the end of the year to which they relate.

Required:

(a) Calculate the NPV of the investment in the new building, explaining your treatment of costs and
depreciation allowances. (10 marks)

(b) Estimate the IRR of this investment (use 15% discount rate as one of your guesses).
(5 marks)

(c) VAS approaches you for advice on whether it should purchase the new building, and asks for
your opinion on payback and accounting rate of return as methods of investment appraisal.
Advise VAS by comparing and contrasting four alternative investment criteria. (5 marks)

(d) Suppose that there is a small probability that the council might change its decision to build a
road, allowing the owner to sell the land for residential development. Outline how this would
change your valuation of the project. (5 marks)

UL12/0005
D01 Page 3 of 5
4. (a) Explain how corporate debt and equity can be thought of as asset combinations of risk free debt
and call and put options on the firms assets. p(8 marks)

(b) Suppose corporate earnings are taxed at the corporate level (tax rate tC) and that earnings
distributed to investors as income on equity are taxed privately (tax rate tE) and earnings
distributed to investors as income on debt are also taxed privately (tax rate tD) but such income is
tax deductible at the corporate level. Explain that in this case the value of a levered firm VL is
equal to the value of an unlevered firm VU plus the value of corporate debt D times a factor
measuring the tax benefits of borrowing 1 (1-tC)(1-tE)/(1-tD). Given that the marginal tax rates
on equity and debt are the same in the UK for most investors. What implications does the above
equation have for an individual firms decision on capital structure? (10 marks)

(c) Eagle Corporation has decided to raise additional equity through a rights issue. The current
market price is 60 per share and Eagle arranges the terms as a 1 for 3 offer at a subscription
price of 50 per share. If we assume a 100% take up of the rights, what is the value of each
right? (7 marks)

Tables

Future value of 1 received Present value of 1, receivable in


today, in n years time at x% n years time at x%

n\ x 10% 20% 30% 10% 20% 30%


1 1.1000 1.2000 1.3000 0.9091 0.8333 0.7692
2 1.2100 1.4400 1.6900 0.8624 0.6944 0.5917
3 1.3310 1.7280 2.1970 0.7513 0.5787 0.4552
4 1.4641 2.0736 2.8561 0.6830 0.4823 0.3501
5 1.6105 2.4883 3.7129 0.6209 0.4019 0.2693

UL12/0005
D01 Page 4 of 5
SECTION B

Answer ONE questions from this section and not more than one further question. (You are reminded that
four questions in total are to be attempted with at least two from Section A.)

5. Critically evaluate the Capital Structure Irrelevance Theory originally proposed by Modigliani and
Miller. (25 marks)

6. The usefulness of financial ratio analysis in the evaluation of a firms performance is severely limited
by a number of factors. Describe and discuss. (25 marks)

7. Describe and discuss the relevance to the real world of the following theories of dividend policy:
Modigliani and Millers irrelevance theory, the dividend clientele theory, agency cost theory, and
signalling theory. (25 marks)

8. Discuss the relevance of the cost of equity capital to investors. Describe two different methods a
company might use to derive its cost of equity capital. Critically discuss the methods explaining why
they may not produce the same result. (25 marks)

9. Briefly explain how the value of a firm going through an initial public offering (IPO) could be
estimated. Critically review the assumptions underlying your proposed method and discuss the quality
and relevance of beta estimates in general. (25 marks)

END OF PAPER

UL12/0005
D01 Page 5 of 5
This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON AC3059 ZB


(279 0059)

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Financial Management

Thursday, 10 May 2012 : 10.00am to 1.00pm

Candidates should answer FOUR of the following NINE questions: TWO from Section A,
ONE from Section B and ONE further question from either section. 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.

Extracts from compound interest tables are given at the end of Section A of this paper.

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 2012


UL12/0006 PLEASE TURN OVER
D01 Page 1 of 5
SECTION A

Answer TWO questions from this section and not more than one further question. (You are reminded that
four questions in total are to be attempted with at least one from Section B.)

1. Solar Products plc has just developed a new product to be called RTC3. The total development cost
amounts to 480,000. The company is now considering whether to put it into production. The
following information is available. Production of RTC3 will require the purchase of new machinery at
a cost of 2,400,000 payable immediately. This machinery is specific to the production of RCT3 and
will be obsolete and valueless when that production ceases. The machinery has a useful production
life of 4 years and a normal production capacity of 30,000 units per annum. The production capacity
can be increased to 40,000 units per year for a one-off modification cost of 50,000. This
modification expense is payable at the beginning of the year in which the company wants to increase
the production capacity. Once the modification is made, the production capacity will stay at 40,000
per year. If the demand exceeds capacity, the company will only be able to sell the products up to the
maximum capacity at the price stated below.

The companys policy is to depreciate this type of machinery using the straight-line depreciation
method.

Production costs per unit of RCT3 are estimated as follows:

Materials 8
Labour 12
Overheads 32

Overheads include the allocated depreciation charge on the new machinery, otherwise they are all
variable production costs to RCT3. The selling price of RCT3 will be 80 per unit. Demand is
expected to fluctuate in accordance with the market condition. A market survey, which was
commissioned prior to the production, has the following findings:

Market Probability Year 1 Year 2 Year 3 Year 4


Condition % units units units units
Good 30 30,000 32,000 35,000 40,000
Average 50 25,000 26,000 27,000 28,000
Bad 20 18,000 17,000 15,000 15,000

The companys effective tax rate is 30% and the capital allowances are at 25% of the written down
value of the machinery at the beginning of each year. Any unrelieved capital allowance will be given
in full in the year of disposal. Tax is payable in the same year to which it is related. To keep things
simple assume the new cash flow per year is treated as the taxable profit before capital allowance.
The after-tax cost of capital for the company is 15%.

Required:

(a) Calculate the after-tax net present value of this project. (17 marks)

(b) Compare and contrast the advantages and disadvantages of Net Present Value and Internal Rate
of Return. (8 marks)

UL12/0006
D01 Page 2 of 5
2. Indigo plc, a company operating in the retail clothing industry, is an all equity company. When the
company was launched on the London Stock Exchange, management issued 20 million 1 shares.
Over the past years, annual dividends per share have been as follows:

Dividends per year (pences)


Two years ago 24.94
Last year 26.20
Current year 27.50

Management have announced that the rate of growth in dividend payments is expected to continue into
the foreseeable future.
The beta value for the retail clothing industry has been estimated at 1.25 and the risk free rate of
interest and the expected return on the market portfolio are currently 4% and 12% respectively.

Required:
(a) Discuss the relevance of the cost of equity for listed companies like Indigo plc. (4 marks)

(b) Calculate the fundamental value of Indigos equity. (6 marks)

(c) Eagle plc operates in the tourism industry. It plans to pay dividends of 10m next year.
Dividends are expected to grow at a rate of 5% per year forever. The current market value of
Eagle plc is 100m. What is your best estimate of Eagles equity beta? (6 marks)

(d) Discuss the strengths and drawbacks of two models of calculating the cost of equity.
(9 marks)
Note: Ignore taxation and assume that the Capital Asset Pricing Model is in equilibrium.

3. Anchor Gaming, a manufacturer of gambling machines, has a market value of 100m and has 40m of
outstanding debt. There are 1 million common shares outstanding. Anchor Gaming has only 2 assets:
gambling assets with a beta of 1.2 and 10m cash. Assume a Modigliani-Miller world for parts (a) to
(d).

Required:
(a) Suppose that Anchor Gaming issues 20m of equity and uses the proceeds to pay down debt.
Thus, after the equity issue, 20m of debt is outstanding. Explain the effect of debt reduction on
firm value. (4 marks)
(b) Suppose now that instead of using the 20m proceeds from the equity issue to pay down debt,
Anchor Gaming uses the proceeds to purchase additional gambling assets. Calculate Anchor
Gamings equity beta after the new equity is issued. Assume that the beta of Anchor Gamings
debt is 0.20 before and after the new equity is issued. (4 marks)
(c) What is the effect of the purchase of the additional gambling assets financed by the equity issue
on the required rate of return on Anchor Gamings equity? (4 marks)
(d) How many shares must Anchor Gaming issue in order to raise 20m? Assume that the proceeds
are used to pay down debt from 40m to 20m. What will the stock price be after the equity
issue? (4 marks)
(e) Describe the additional information one would need to value the costs and benefits of Anchor
Gamings capital structure choice in a world with corporate taxes and bankruptcy costs and how
one would use this information. (9 marks)

UL12/0006
D01 Page 3 of 5
4. Bidder plc is considering the acquisition of Target plc. You have been asked to evaluate the merits of
the proposed acquisition. Here are the data on the two companies before the acquisition.
Target Bidder
Number of shares outstanding 1,000m 5,000m
P-E ratio 10 2
Expected earnings per share () 0.5 3
Bidder has valued the synergies from the acquisition as being 2,500m.

Required:
(a) If Bidder wishes to finance the acquisition with shares in the merged firm, what is the maximum
number of shares it would be willing to offer to Targets shareholders? (5 marks)

(b) What would be the consequences of such a bid on expected earnings per share if we assume that
the synergies will lead to an increase in expected earnings of 200m in the first year? Does the
effect on earnings per share of the merged firm affect the merit of the transaction? Explain.
(5 marks)

(c) Instead of the share exchange, Bidder has sufficient surplus cash to finance the acquisition with a
cash offer. Alternatively, Bidder could return the cash to its shareholders before making the bid
and proceed with the share exchange. How would you advise Bidder to decide between the
share offer and returning the cash to shareholders versus using the cash to finance the
acquisition? (7 marks)

(d) Independently of the example above, what mechanisms do companies adopt in an effort to
prevent takeovers? Given that the targets shareholders typically benefit from a takeover, can
these takeover defences ever be justified? (8 marks)

Tables

Future value of 1 received Present value of 1, receivable in


today, in n years time at x% n years time at x%

n\ x 10% 20% 30% 10% 20% 30%


1 1.1000 1.2000 1.3000 0.9091 0.8333 0.7692
2 1.2100 1.4400 1.6900 0.8624 0.6944 0.5917
3 1.3310 1.7280 2.1970 0.7513 0.5787 0.4552
4 1.4641 2.0736 2.8561 0.6830 0.4823 0.3501
5 1.6105 2.4883 3.7129 0.6209 0.4019 0.2693

UL12/0006
D01 Page 4 of 5
SECTION B

Answer ONE questions from this section and not more than one further question. (You are reminded that
four questions in total are to be attempted with at least two from Section A.)

5. Critically evaluate the Capital Structure Irrelevance Theory originally proposed by Modigliani and
Miller. (25 marks)

6. Provide and critically discuss motivations for engaging in mergers and acquisitions. (25 marks)

7. Describe and discuss the relevance to the real world of the following theories of dividend policy:
Modigliani and Millers irrelevance theory, the dividend clientele theory, agency cost theory, and
signalling theory. (25 marks)

8. Identify five ratios which may be used to assess a firms performance as well as its main determinants.
Discuss the pertinence of ratio analysis when assessing a firms performance. (25 marks)

9. Corporate valuation techniques are the same whether a valuation is required in the context of mergers
and acquisitions or by a private investor. Discuss. (25 marks)

END OF PAPER

UL12/0006
D01 Page 5 of 5
Examiners commentaries 2012

Examiners commentaries 2012


AC3059 Financial management

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. 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


Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2012).

General remarks

Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
discuss the theoretical models underpinning the practices in financial
management
apply the techniques derived from the models and theories in financial
management
explain the long- and short-term financial needs of a business
describe the techniques used for the selection and management of long
and short-term assets
discuss and give examples of the wider aspects of financial
management so as to include international considerations and the need
to communicate decisions made to other members of a management
team.

Format of the examination


The examination is three hours long, during which you should answer
four questions from a selection of nine. The paper has two sections, A
and B, with four questions in Section A and five in Section B. 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 parts 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.

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

1
AC3059 Financial management

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 judgment is
required, then it should be demonstrated in the 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
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, 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 42 minutes per question in which to write your answer.

2
Examiners commentaries 2012

Ensure your written answers to your practice questions do attempt


to answer the question posed and not the one you wish you could be
answering. Learn to focus your answer on the contents, context and
requirements of that specific question.

Updating of Essential reading


The core textbook is now Brealey, Myers, and Marcus, Principals of
Corporate Finance. (McGraw Hill International Edition, 2010) [ISBN
9780071314176]. In the specific comments for the Zone A and B papers,
the chapter numbers are given for this particular edition.

Question spotting
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This can be due to a number
of different reasons and the Examiners commentaries suggest ways
of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question
spotting, that is, confining your examination preparation to a few
question topics which have come up in past papers for the course. This
can have very serious consequences.
We recognise that candidates may 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 in the
section of the VLE dedicated to this course. You should read the
syllabus very 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 every
topic on the syllabus is a legitimate examination target. So although
past papers can be helpful in 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 paper. We strongly advise you not to adopt
this strategy.

3
AC3059 Financial management

Examiners commentaries 2012


AC3059 Financial management Zone A

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. 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


Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2012).

Comments on specific questions


Candidates should answer FOUR of the following NINE questions: TWO
from Section A, ONE from Section B and ONE further question from either
Section. 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.
Extracts from compound interest tables are given at the end of Section A
of this paper.
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.

Section A
Answer TWO questions from this section and not more than one further question.
(You are reminded that four questions in total are to be attempted with at least
one from Section B.)

Question 1
Dreyers Grand Ice Cream Holdings Inc. is a publicly-held US company that has two
primary businesses: ice cream manufacturing and ice cream distribution. Dreyers
assets have a total market value of $180m of which 70% are manufacturing assets
and 30% are distribution assets. The beta for manufacturing assets is 0.47. Dreyers
equity beta is 0.75. Dreyers only liability is $20m of long-term debt with a beta of
0.3. The current share price is $22.86 and there are 7m shares outstanding. Assume
that the risk-free rate is equal to 5%.
Required:
a. What is Dreyers overall asset beta? (6 marks)
b. Dreyers is considering selling the distribution assets and investing the
proceeds in short-term government bonds. If Dreyers goes through this,
would the firms equity beta increase, decrease, or stay the same? (4 marks)

4
Examiners commentaries 2012

c. Redden Microbatch Ice Cream Inc., a privately held firm, markets and sells
super premium ice cream. Unlike Dreyers, Redden Microbatch does not
manufacture its own ice cream. Redden Microbatch will go through an IPO
this week. If you were to value Redden Microbatch, explain which discount
rate you would use in order to calculate the present value of future free cash
flows to all claimholders. Assume that the market risk premium is 8.4%.
(6 marks)
d. Redden Microbatch has a capital structure consisting of 25% debt and
75% of equity. Its debt has a beta of 0.35. If you were to value Redden
Microbatchs equity, explain which discount rate you would use in order to
calculate the present value of dividends? (6 marks)
e. During the road show for institutional investors, the founders of Redden
Microbatch indicated that the companys hurdle rate was 25%. How does this
particular information influence your opinion of the company? (3 marks)
Reading for this question
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New
York: McGraw Hill Inc, 2010) [9780071314268], Chapters 10 and 20.
Subject guide, Chapter 8.
Approaching the question
This question tests candidates understanding of how a firms beta can be
determined. It exploits the fact that a firms asset beta can be determined
as a weighted average of the asset betas of the firms assets. It also exploits
the fact that a firms asset beta can be determined as a weighted average
of the betas of the financial claims on the firm (equity and debt in the
context of this question).
a. Dreyers overall asset beta must equal the weighted average of the debt
and equity beta:
A = [D/(D + E)]D + [E/(D + E)] E
with:
E = $22.86 * 7m = $160m
D/(D+E) = $20m/($20m +$160m) = 11.1%
E/(D+E) = 1 [D/(D+E)] = 88.9%
D = 0.3
E = 0.75
Hence: A = 0.70
b. In this scenario, the assets of Dreyers will change. In fact, 30 per cent
of the firms assets will now be invested in risk-free securities (or lower
risk assets). Since the firms assets are now less risky the asset beta
has fallen the equity beta will be lower. Dreyers will have the same
financial leverage as before, but less business risk.
c. Dreyers beta of assets, A, is given by:
A = 30%*DA + 70%*MA
where DA denotes the beta of distribution assets and MA denotes the
beta of manufacturing assets.
Hence: DA= [A 70%*MA]/30% = [0.70 0.70*0.47]/0.30 = 1.24
And: E(rDA) = rF + DA [E(rM) rF] = 5% + 1.24*8.4% = 15.39%
d. Let us denote the beta of Redden Microbatchs debt by RMD and the
cost of Redden Microbatchs debt by E(rRMD). Then:

5
AC3059 Financial management

E(rRMD) = rF + RMD [E(rM) rF] = 5% + 0.35*8.4% = 7.94%


And hence:
E(rRME) = E(rDA)+(DRM/ERM)[E(rDA)E(rRMD)] = 15.4%+(25/75)
(15.4%7.9%) = 17.9%
e. This information motivates the IPO. Such a high hurdle rate is
consistent with Reddens founders pricing idiosyncratic risk as he or
she had not diversified.

Question 2
Consider a strategic (i.e. value enhancing) merger/takeover between two firms
A and B. Firm A has 100,000 shares outstanding priced at $2 each, and firm B
200,000 shares priced at $1 each. If a merger takes place, the new firm could
make cost savings in production and marketing of $4,000 each year indefinitely.
The cost of capital is 10%.
Required:
a. Suppose firm A proposes a bid for firm Bs shares worth $1.2 each,
and also suppose the bid is going to be accepted for sure by all of Bs
shareholders. Work out the change in price in Firm As shares following the
bid announcement by a rational market which takes the announcement as
a complete surprise. Do you think firm A is overpaying for firm Bs shares?
Explain your answer. (8 marks)
b. Suppose now that the two firms have agreed to a merger where each share
in firm A will be converted into 2 shares in the merged firm, and each share
in firm B will be converted into 1 share in the merged firm. Work out the
change in price in Firm As shares in response to the announcement of the
merger, making similar assumptions as in (a). (9 marks)

DISCOUNT TABLES
PERIOD INTEREST RATES
10% 15%
1 0.9091 0.8696
2 0.8264 0.7561
3 0.7513 0.6575
4 0.6830 0.5718
5 0.6209 0.4972
c. What mechanisms do companies adopt in an effort to prevent takeovers?
Given that the targets shareholders typically benefit from a takeover, can
these takeover defences ever be justified? (8 marks)
Reading for this question
Brealey et al. (2010), Chapter 32.
Subject guide, Chapters 5 and 10.
Approaching the question
This question tests candidates understanding of valuation in the context
of mergers and acquisitions and price responses to new information in
efficient capital markets.
a. VA = 100,000*$2 = $200,000
VB = 200,000*$1 = $200,000
S = $4,000/10% = $40,000
Bid = 200,000*$1.2 = $240,000

6
Examiners commentaries 2012

Change in VA = VA + S Bid
= $200,000 + $40,000 $240,000 = $0.
This is a zero NPV transaction for the acquiror. Shareholders of
the target firm get 100 per cent of the surplus generated by the
acquisition.
b. Total number of shares: 100,000*2 +200,000*1 = 400,000.
Number of shares provided to firm A equityholders: 200,000.
VAB = VA + VB + S = $440,000.
Change in VA = VAB /2 VA = $220,000 $200,000 = $20,000.

Question 3
Visual-Audio Systems (VAS) Ltd is a video production company and currently
rents the building in which its production equipment is located at an annual cost
of 150,000, including all service charges.
The company is considering purchasing an alternative building in which to
undertake its video business. These alternative premises are due to be demolished
by the local council in 4 years time, to make way for a new road and it is known
that the council, will purchase the building at that time for 100,000. Because
of the instability caused by the Councils plans, VAS can purchase the building
at a knock-down price of 250,000. Otherwise, since the building is located in a
prime residential area, the land on which the building stands would be worth 1.8
million. Currently the building is in a state of disrepair, but a structural survey
which has already been undertaken by VAS costing 3,000, recommends that the
building must be upgraded at a cost of 50,000 before VAS moves in.
The annual heating and lighting expenses on the new building will be 40,000,
but VAS will save the annual rents on its current premises. The removal costs of
moving its equipment into the new building, and the cost of moving out again in
five years time will be 25,000 on each occasion.
VAS pays corporation tax on its profits at 30%, and the tax authorities allow
VAS to offset its corporate tax liabilities by using straight line depreciation on
its fixed assets. You may assume that VAS has sufficient taxable profits to take
full advantage of any tax shields from purchasing the building. VAS applies an
opportunity cost of capital of 10 per cent to all future cash flows. Assume all
annual cash-flows occur at the end of the year to which they relate.
Required:
a. Calculate the NPV of the investment in the new building, explaining your
treatment of costs and depreciation allowances. (10 marks)
b. Estimate the IRR of this investment (use 15% discount rate as one of your
guesses). (5 marks)
c. VAS approaches you for advice on whether it should purchase the new
building, and asks for your opinion on payback and accounting rate of
return as methods of investment appraisal. Advise VAS by comparing and
contrasting the four alternative investment criteria. (5 marks)
d. Suppose that there is a small probability that the Council might change its
decision to build a road, allowing the owner to sell the land for residential
development. Outline how this would change your valuation of the project.
(5 marks)
Reading for this question
Brealey et al. (2010) Chapters 2, 6, and 7.
Subject guide, Chapter 2.

7
AC3059 Financial management

Approaching the question


This question tests candidates understanding of investment appraisal. The
main challenge is to identify incremental cash-flows after taxes associated
with the project. Some candidates were somewhat confused by the
difference between capital allowances and depreciation expenses.
a. The incremental cash-flows after tax generated by the project are given
in the following table:

000 Y0 Y1 Y2 Y3 Y4
Rent saved 150 150 150 150
Property transactions 250 100
Property upgrade 50
Expenses 40 40 40 40
Removal costs 25 25
CF before tax 325 110 110 110 185
Depreciation expense 50 50 50 50
Tax effect 7.5 18 18 18 10.5
CF after tax 317.5 92 92 92 174.5

Depreciation expense (000):


(250 + 50 100) = 50
Tax effect in Y0 (000):
30%*(25) = 7.5
Tax effect in Y1, Y2 and Y3 (000):
30%(150 40 50) = 18
Tax effect in Y4 (000):
30% (150 40 25 50) = 10.5
NPV = 30.5 (000)
b. Derivation of the IRR:
NPV, with a 15% discount rate = 7.67
Interpolate x/30 = (0.15 0.1)/(30 + 8)
x= 0.039944
IRR = 0.1 + x = 0.139944 = 13.99%
IRR = 14%
c. According to NPV and IRR criteria, VAS should invest.
Advantage-disadvantages of investment appraisal methods
1. DCF techniques are best for investment appraisal since they take
account of time value and risk of money.
2. But the IRR method may suffer:
a. in the context of project selection with mutually exclusive
projects
b. as there may be multiple IRRs
c. as it ignores the size of the project.
3. ARR suffers as:
a. it does not consider cash-flows
b. it may be difficult to find a benchmark for comparison purposes

8
Examiners commentaries 2012

c. it ignores the time value of money


d. it ignores the size of the project IRR may suffer from.
4. Payback ignores discounting ARR suffers from.
d. If there is a chance that the land could be worth 1.8million, then this
increases the NPV of the project, since the decision to purchase the
building includes the option to sell the land for residential development.
In which case the firm has a sequential valuation with the current
NPV of 30.47K with probability of (1p) if the Council sticks with
its decision to build the road, but if the Council changes its decision
with probability of p, the value of the land could increase to 1.8m.
In addition in this state, VAS will be able to choose whether to sell the
land for residential purchase or keep it as a video studio in perpetuity.

Question 4
a. Explain how corporate debt and equity can be thought of as combinations of
risk free debt and call and put options on the firms assets. (8 marks)
b. Suppose corporate earnings are taxed at the corporate level (tax rate tC)
and that earnings distributed to investors as income on equity are taxed
privately (tax rate tE) and earnings distributed to investors as income on debt
are also taxed privately (tax rate tD) but such income is tax deductible at
the corporate level. Explain that in this case the value of a levered firm VL is
equal to the value of an unlevered firm VU plus the value of corporate debt D
times a factor measuring the tax benefits of borrowing 1 (1 tC)(1 tE)/(1
tD). Given that the marginal tax rates on equity and debt are the same in the
UK for most investors. What implications does the above equation have for
an individual firms decision on capital structure? (10 marks)
c. Eagle Corporation have decided to raise additional equity through a rights
issue. The current market price is 60 per share and Eagle arranges the terms
as a 1 for 3 offer at a subscription price of 50 per share. If we assume a
100% take up of the rights, what is the value of each right? (7 marks)
Tables

Future value of 1 received today, in n Present value of 1, receivable in n years


years time at x% time at x%
n\ x 10% 20% 30% 10% 20% 30%
1 1.1000 1.2000 1.3000 0.9091 0.8333 0.7692
2 1.2100 1.4400 1.6900 0.8624 0.6944 0.5917
3 1.3310 1.7280 2.1970 0.7513 0.5787 0.4552
4 1.4641 2.0736 2.8561 0.6830 0.4823 0.3501
5 1.6105 2.4883 3.7129 0.6209 0.4019 0.2693
Reading for this question
Brealey et al. (2010), Chapters 16, 21 and 22.
Subject guide, Chapter 6.
Approaching the question
This question tests candidates understanding of capital structure issues.
Part a) takes an option perspective on capital structure. Part b) considers
both corporate taxes and personal taxes. Part c) deals with equity issues
coming in the form of rights issues.
a. Suppose the assets of a firm are worth V. The firm is financed partly by
debt, and the debt liability X is due for repayment in T years time.
Pay-off to equityholders at debts maturity date:

9
AC3059 Financial management

VT X if VT X;
0 if VT X.
Equity can hence be thought of as a call option on the firms assets,
where the exercise price is equal to the debt liability X due for
repayment;
Pay-off to debtholders at debts maturity date:
X if VT X;
VT if VT X.
This pay-off can be rewritten as the sum of the pay-offs from:
a risk-free debt contract generating X ;
the writing of a put option generating :
0 if VT X;
VT X if VT X.
The firms debt can hence be thought of as a risk free debt contract
minus a put option on the firms assets, where the exercise price is
equal to the debt liability X due for repayment.
b. Consider a firm with pre-tax cash-flow X, debt D, and interest
payments rDD;
The cash-flow after tax is hence equal to:
C = (X rDD)(1 tC)(1 tE) + rDD(1 tD)
= X(1 tC)(1 tE) + rDD[(1 tD) (1 tC)(1 tE)]
with the second term denoting the gain from leverage.
If the firm generates pre-tax cash-flow X forever and the level of debt is
permanently fixed, the after-tax cash-flow (as well as the tax gain from
leverage) becomes a perpetuity;
The appropriate discount rate for the second term is rD(1 tD);
It then follows that the value of the levered firm V satisfies the
following relation:
V = VU + D[1 ((1 tC)(1 tE)/(1 tD))]
with VU denoting the value of the unlevered firm.
The second term represents the value from leverage.
c. Pre-issue, a shareholder with three shares and 50 in cash has worth
equal to 60*3 +50 = 230. Post-issue, each share is worth 230/4
= 57.5. The gain in the share price of the share purchased is hence
7.50, which is split between the three original shares, so that the
value of the rights per share is 2.5.

Section B
Answer one question from this section and not more than one further question.
(You are reminded that four questions in total are to be attempted with at least
two from Section A.) (25 marks)

Question 5
Critically evaluate the Capital Structure Irrelevance Theory originally proposed
by Modigliani and Miller.
Reading for this question
Brealey et al. (2010), Chapter 18.
Subject guide, Chapter 6.
10
Examiners commentaries 2012

Approaching the question


This question tests candidates understanding of MMs capital structure
irrelevancy proposition. While most candidates were able to provide some
assumptions behind the theory and explain what the theory was all about,
the question asked for a critical evaluation of the theory.
Brealey et al. (2010), Chapter 17, pp.44652 begins with an explanation
of the irrelevance of capital structure. The key points of Modigliani and
Millers arguments are summarised below:
Assumptions:
Capital markets are frictionless with no transaction costs.
Individuals and corporations can borrow and lend at the risk-free rate.
All firms are in the same risk class and all cash flow streams are
perpetuities (namely, no growth).
There is no taxation in the world (no corporate tax nor personal taxes).
There is no cost on bankruptcy (namely, debt is risk free).
Corporate insiders and outsiders share the same set of information
(namely, no signalling opportunities).
Managers always maximise shareholders wealth (namely, no agency
costs).
Under this setting where there are no taxes and capital markets are
functioning properly, Modigliani and Miller argue that it makes no
difference whether a firm or an individual shareholder borrows. The
market value of a company does not depend on its capital structure.
This is a highly unrealistic and restrictive set of assumptions. It could be
argued that all assumptions are violated. Furthermore, empirical evidence
obtained from large sample studies suggests that capital structure does
matter. For instance, repurchases of equity financed with issues of
debt are associated with positive cumulative abnormal returns around
announcement dates.

Question 6
The usefulness of financial ratio analysis in the evaluation of a firms
performance is severely limited by a number of factors. Describe and discuss.
(25 marks)
Reading for this question
Brealey et al. (2010), Chapter 29.
Subject guide, Chapter 11.
Approaching the question
A good quality answer to this question should not just describe a number
of financial ratios that the candidate thinks are appropriate but should lay
the foundations by first identifying the general limitations of ratio analysis
and what implications they may have when trying to assess the ratios
being used to measure a firms performance. There are quite a number
of limitations and a candidate is expected to know the majority. The
limitations include such points as the fact that the accounting numbers
are historical and may well be out of date; that there are some differences
in accounting definitions and techniques in principle, as well as between
companies; there are differences over time due to changes in both the
economic and reporting environments; one may not have appropriate
standards for comparison, particularly bearing in mind that short-run
fluctuations may be hidden and that the numbers from a balance sheet
11
AC3059 Financial management

only reflect that one datum point. Accounts are published documents and so
their authors may want to include some window dressing, or be economical
in their notes to the accounts which can exacerbate an analysts problems
particularly when reviewing the accounts of a diversified company. A final
point worth making is that the past as reflected in the accounts may not
be a good predictor of the future. Naturally an answer should include brief
descriptions/definitions of various ratios deemed to be appropriate such
as a firms return on capital, return on equity, return on asset and their
determinants. These too should come with comments and criticisms as well
as descriptions.
Finally, a very good answer would mention that there are no successful
statistical models using these ratios to evaluate or predict profitability, only
models for predictions of bankruptcy or levels of creditworthiness.

Question 7
Describe and discuss the relevance to the real world of the following theories of
dividend policy: Modigliani and Millers irrelevance theory, the dividend clientele
theory, agency cost theory, and signalling theory. (25 marks)
Reading for this question
Brealey et al. (2010), Chapter 17.
Subject guide, Chapter 7.
Approaching the question
This question tests candidates understanding of dividend policies. A good
answer should not only explain the relevant theories of dividend policy but
should also explain their relevance to the real world. The arguments can be
found in the subject guide.

Question 8
Discuss the relevance of the cost of equity capital to investors. Describe two
different methods a company might use to derive its cost of equity capital. Critically
discuss the methods explaining why they may not produce the same result.
(25 marks)
Reading for this question
Brealey et al. (2010), Chapter 9.
Subject guide, Chapters 3 and 9.
Approaching the question
This question tests candidates understanding of the cost of equity. Candidates
are expected to mention that the cost of equity capital gives managers an
indicator of the returns required by shareholders on their investment in
the company. Candidates are further expected to introduce both Gordons
dividend growth model and the Capital Asset Pricing Model. A good answer
should include a comparative discussion of the strengths and limitations of
the two models. For example, multi-period for Gordon versus single period
for CAPM; no accounting for risk in Gordon; changing values of the variables
over time, particularly g and ; and difficulties over the derivation of the
variables values, such as the market and riskless interest rates, and so on.

Question 9
Briefly explain how the value of a firm going through an initial public offering
(IPO) could be estimated. Critically review the assumptions underlying your
proposed method and discuss the quality and relevance of beta estimates in
general. (25 marks)

12
Examiners commentaries 2012

Reading for this question


Brealey et al. (2010), Chapter 10.
Subject guide, Chapters 3 and 8.
Approaching the question
Candidates should mention listed comparable firms. Using the market
model and regressions analysis, one may estimate betas of equity, and
through reverse engineering, asset betas. These asset betas can then be
used alongside the IPO firms leverage to estimate its equity beta.
Candidates may comment on problems finding comparable firms.
Furthermore, many firms compete in multiple industries (this is not
really a problem though as the firms asset beta will be a weighted
average of the betas of the different types of assets). Candidates may also
comment on the application of regression analysis to the relationship
between periodic rates of return for a company to those of the stock
market. Having determined , which is the slope of the regression line,
by this method, candidates may discuss the problems associated with
its estimation, for example, whether the periods taken are weekly, daily,
monthly, etc.; what is the quality/accuracy of the estimate of ; namely,
the size of the r and how this can be very different from one company
to another. Similarly, what is the relative size of the standard deviation of
the estimate of to (the larger the proportion, the poorer the estimate).
Then there is the topic of how statisticians deal with the practical
problems that can arise when doing the regression analysis. Daily prices
may not always be available or may not change for a significant period
of time (in a thin market) or the choice of the overall time period under
study may influence the size. Should one include periods when the
market crashes? How stable is over time? Is it the same from one period
to the next? This is important since CAPM is a single period model, yet its
results for are used in multi-period estimates.

13
AC3059 Financial management

Examiners commentaries 2012


AC3059 Financial management Zone B

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. 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


Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2012).

Comments on specific questions


Candidates should answer FOUR of the following NINE questions: TWO
from Section A, ONE from Section B and ONE further question from either
Section. 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.
Extracts from compound interest tables are given at the end of Section A
of this paper.
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.

Section A
Answer TWO questions from this section and not more than one further question.
(You are reminded that four questions in total are to be attempted with at least
one from Section B.)

Question 1
Solar Products plc has just developed a new product to be called RTC3. The
total development cost amounts to 480,000. The company is now considering
whether to put it into production. The following information is available.
Production of RTC3 will require the purchase of new machinery at a cost of
2,400,000 payable immediately. This machinery is specific to the production
of RCT3 and will be obsolete and valueless when that production ceases. The
machinery has a production life of 4 years and a normal production capacity of
30,000 units per annum. The production capacity can be increased to 40,000
units per year for a one-off modification cost of 50,000. This modification
expense is payable at the beginning of the year in which the company wants to
increase the production capacity. Once the modification is made, the production

14
Examiners commentaries 2012

capacity will stay at 40,000 per year. If the demand exceeds capacity, the
company will only be able to sell the products up to the maximum capacity at
the price stated below.
The companys policy is to depreciate this type of machinery using the straight-
line depreciation method.
Production costs per unit of RCT3 are estimated as follows:

Materials 8
Labour 12
Overheads 32
Overheads include the allocated depreciation charge on the new machinery,
otherwise they are all variable production costs to RCT3. The selling price of
RCT3 will be 80 per unit. Demand is expected to fluctuate in accordance with
the market condition. A market survey, which was commissioned prior to the
production, has the following findings:

Market condition Probability % Year 1 Year 2 Year 3 Year 4


units units units units
Good 30 30,000 32,000 35,000 40,000
Average 50 25,000 26,000 27,000 28,000
Bad 20 18,000 17,000 15,000 15,000
The companys effective tax rate is 30% and the capital allowances are at 25%
of the written down value of the machinery at the beginning of each year. Any
unrelieved capital allowance will be given in full in the year of disposal. Tax is
payable in the same year to which it is related. To keep things simple assume the
new cash flow per year is treated as the taxable profit before capital allowance.
The after-tax cost of capital for the company is 15%.
Required:
a. Calculate the after-tax net present value of this project. (17 marks)
b. Compare and contrast the advantages and disadvantages of Net Present
Value and Internal Rate of Return. (8 marks)
Reading for this question
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New
York: McGraw Hill Inc, 2010) [ISBN 9780071314176], Chapters 2, 6,
and 7.
Subject guide, Chapter 2.
Approaching the question
a. This question tests candidates understanding of investment appraisal.
The main challenge is to identify incremental cash-flows after taxes
associated with the project. This task is made more complex by the
option decision to incur the modification cost. Some candidates were
somewhat confused by the difference between capital allowances and

15
AC3059 Financial management

depreciation expenses.
0 1 2 3 4
Machine (000) (2,400)
Net contribution (000) 1204.8 1248 1296 1392
Modification cost (000) (15) (10.5) (7.35)
NCF before tax (000) (2,400) 1204.8 1233 1285.5 1,384.65
Tax (000) (181.44) (234.9) (284.4) (111.645)
NCF after tax (000) (2,400) 1023.36 998.1 1001.1 1273.005
D.F. (15%) 1 0.87 0.757 0.658 0.572
PV (000) (2,400) 890.323 755.562 658.724 728.159
NPV: 632,768
Workings:
1. Depreciation expense per year: 2,400,000/4 = 600,000
Depreciation expense per unit: 600,000/30,000 = 20
2. Derivation of the contribution per unit ():
Sales 80
Labour 12
Materials 8
Overheads 12
Contribution 48
3. Derivation of expected demand:
Yr1: 30%*30,000 + 50%*25,000 + 20%*18,000 = 25,100
Yr2: 30%*32,000 + 50%*26,000 + 20%*17,000 = 26,000
Yr3: 30%*35,000 + 50%*27,000 + 20%*15,000 = 27,000
Yr4: 30%*40,000 + 50%*28,000 + 20%*15,000 = 29,000
4. Derivation of capital allowances:
0 1 2 3 4
Written Down Value (000) 2,400 1,800 1,350 1,012.5
Capital Allowances (000) 600 450 337.5 1,012.5

5. Derivation of Tax:
0 1 2 3 4
Taxable profit before capital allowances (000) 1,204.8 1,233 1,285.5 1,384.65
Capital allowances (000) 600 450 337.5 1,012.5
Taxable profit after capital allowances (000) 604.8 783 948 372.15
Tax (30%) 181.44 234.9 284.4 111.645
6. Decision whether or not to incur the modification cost:
In Yr2, there is a 30 per cent chance that the demand exceeds 30,000
units. The expected modification cost is therefore 30%*50,000 =
15,000. The additional contribution from the extra 2,000 units would
be 48*2,000 = 96,000, which exceeds 50,000. The modification
should hence be implemented.
In Yr3, the probability that demand exceeds 30,000 units is 30 per
cent. The probability of incurring the modification cost in Yr3 is hence
70%*30% = 21% and the expected modification cost is therefore

16
Examiners commentaries 2012

21%*50,000 = 10,500.
In Yr4, the expected modification cost is 70%*70%*30%*50,000 =
7,350.
b. NPV Method:
Uses the discounting principle.
The NPV of a project is the difference between the PV of all the
cash-inflows generated by the project net of the present value of
the cash investments associated with the same project:
Incremental cash-flows;
Discount rate: opportunity cost of capital.
According to the NPV rule, a project should be taken if the NPV
is weakly positive;
Additive property;
Works with mutually exclusive projects;
Works with limited funds.
IRR Method:
The IRR is the discount rate for which the NPV of a project is nil;
The IRR is then compared with a hurdle rate;
If the IRR exceeds the hurdle rate, the project should be taken;
If the hurdle rate is equal to the opportunity cost of capital used
in the NPV method, both methods give the same results.
Problems with the IRR method:
There may be no IRR;
There may be multiple IRR;
The IRR method may give the wrong answer if the first outflow
is positive and subsequent outflows are negative;
Problems when dealing with mutually exclusive projects.

Question 2
Indigo plc, a company operating in the retail clothing industry, is an all equity
company. When the company was launched on the London Stock Exchange,
management issued 20 million 1 shares. Over the past years, annual dividends
per share have been as follows:
Dividends per year (pences)
Two years ago 24.94
Last year 26.20
Current year 27.50
Management have announced that the rate of growth in dividend payments is
expected to continue into the foreseeable future.
The beta value for the retail clothing industry has been estimated at 1.25 and
the risk free rate of interest and the expected return on the market portfolio are
currently 4% and 12% respectively.
Required:
a. Discuss the relevance of the cost of equity for listed companies like Indigo

17
AC3059 Financial management

plc. (4 marks)
b. Calculate the value of Indigos equity. (6 marks)

DISCOUNT TABLES
PERIOD INTEREST RATE (15%)
1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
c. Eagle plc operates in the tourism industry. It plans to pay dividends of 10m
next year. Dividends are expected to grow at a rate of 5% per year forever.
The current market value of Eagle plc is 100m. What is your best estimate of
Eagles equity beta? (6 marks)
d. Discuss the strengths and drawbacks of two models of calculating the cost of
equity. (9 marks)
Note: Ignore taxation and assume that the Capital Asset Pricing Model is in
equilibrium.
Reading for this question
Brealey et al. (2010), Chapter 9.
Subject guide, Chapters 3 and 9.
Approaching the question
a. The cost of equity capital gives managers an indicator of the returns
required by shareholders on their investment in the company, and
if the company is an all-equity financed company then it would also
be the overall or weighted average cost of capital (WACC) for the
company as well as the required return on the companys investments.
Thus it is the hurdle rate to be used in project appraisal by such a
company.
b. Growth rates:
(26.2 24.94)/24.94 = 5.05%
(27.5 26.2)/26.2 = 4.96%
Expected growth rate: 5%
E(D1) = D0*(1 + g) = 20m*0.275*(1 + 5%) = 5.775m
rE = rF + E[E(rM) rF] = 4% + 1.25(12% 4%) = 14%
V0 = E(D1)/( rE g) = 64.2m
c. Suggested solution:
rE = E(D1)/ V0 + g = (10m/100m) + 5% = 15%.
d. The Gordon model assumes a constant rate of dividend growth, in
spite of that not necessarily being so in practice. It states that the
cost of equity is equal to the predicted dividend yield plus the growth
rate in dividends. It is derived from past years data, but the result
can be adjusted if it is felt that the present and the future underlying
economic environment is felt to be out of line with the past. It is
based solely on dividends and takes no account of the risk class of the
companys equity.
CAPM is an estimate based on regression analysis of the past
relationship of the share price relative to changes in the market index.
The analysis gives a value for , the extent of the relationship, which

18
Examiners commentaries 2012

is then incorporated into the formula that Ke = Kr + e (Km Kr),


where Ke is the companys rate of return, Km and Kr are the market
and riskless rates of return, and e is the companys risk factor defined
above. So it is argued that measures the link between the risk level of
the company and the required return by the market for that level.
Since the focus of each model is different one is a multi-period
model, the other a single period model, and both are based on
forecasts but with different variables it is quite possible for them to
produce different results.

Question 3
Anchor Gaming, a manufacturer of gambling machines, has a market value of
100m and has 40m of outstanding debt. There are 1 million common shares
outstanding. Anchor Gaming has only 2 assets: gambling assets with a beta of
1.2 and 10m cash. Assume a Modigliani-Miller world for parts a) to d).
Required:
a. Suppose that Anchor Gaming issues 20m of equity and uses the proceeds
to pay down debt. Thus, after the equity issue, 20m of debt is outstanding.
Explain the effect of debt reduction on firm value. (4 marks)
b. Suppose now that instead of using the 20m proceeds from the equity issue
to pay down debt, Anchor Gaming uses the proceeds to purchase additional
gambling assets. Calculate Anchor Gamings equity beta after the new equity
is issued. Assume that the beta of Anchor Gamings debt is 0.20 before and
after the new equity is issued. (4 marks)
c. What is the effect of the purchase of the additional gambling assets financed
by the equity issue on the required rate of return on Anchor Gamings equity?
(4 marks)
d. How many shares must Anchor Gaming issue in order to raise 20m? Assume
that the proceeds are used to pay down debt from 40m to 20m. What will
the stock price be after the equity issue? (4 marks)
e. Describe the additional information one would need to value the costs
and benefits of Anchor Gamings capital structure choice in a world
with corporate taxes and bankruptcy costs and how one would use this
information. (9 marks)
Reading for this question
Brealey et al. (2010), Chapters 10, 16, and 18.
Subject guide, Chapters 5 and 8.
Approaching the question
This question tests candidates understanding of capital structure and the
effect of a firms capital structure on the firms equity beta. It exploits the
fact that a firms asset beta can be determined as a weighted average of
the asset betas of the firms assets. It also exploits the fact that a firms
asset beta can be determined as a weighted average of the betas of
the financial claims on the firm (equity and debt in the context of this
question).
a. Balance sheets before and after the issue of equity can be found in the
following tables:
Balance sheet (Prior to the Issue of Equity)
Cash $10m Debt $40m

19
AC3059 Financial management

Gambling Assets $90m Equity $60m

Balance sheet (After the Issue of Equity)


Cash $10m Debt $20m
Gambling assets $90m Equity $80m
In the Modigliani-Miller world, the firm value is independent of the
firms capital structure and equal to the value of the firms assets.
b. The balance sheet after the issue of equity can be found in the
following table:
Balance sheet (After the Issue of Equity)
Cash $10m Debt $40m
Gambling assets $110m Equity $80m
The beta of equity after the issue of equity can be estimated from:
= V E + V D =
GA
E D TA GA
A
V
E + V D V
E + V D

It hence follows that:

V E V D V D
GA +
E
=
TA GA V E V E D

By substituting appropriate numerical values, one obtains:


E = 1.55
c. Suggested solution:
Asset effect: Increase in the cost of equity capital
Leverage effect: Decrease in the cost of equity capital
Before the purchase of the additional gambling assets financed by
the equity issue, Anchor Gamings equity was:
E = A + (VD/VE)(A D) = 1.67
The equity beta and the required rate of return have thus fallen as a
result of the purchase of the additional gambling assets financed by
the equity issue.
d. After new equity is issued, total equity value is $80 million. This
consists of the original $60 million equity value plus the $20 million
contributed by new equity holders. Therefore, we can write the
following equation, where N is the new number of shares issued:
PNew = VE/(N + 1m)
Furthermore:
PNew N = $20m
Solving these two equalities yields:
PNew = $60 and N = 333,333 shares
e. Information about:
Distribution of taxable profits;
Alternatives for tax shields;
Probability of bankruptcy associated with different levels of debt;

20
Examiners commentaries 2012

Costs of bankruptcy.

Question 4
Bidder plc is considering the acquisition of Target plc. You have been asked to
evaluate the merits of the proposed acquisition. Here are the data on the two
companies before the acquisition.
Target Bidder
Number of shares outstanding 1,000m 5,000m
P-E ratio 10 2
Expected earnings per share () 0.5 3
Bidder has valued the synergies from the acquisition a being 2,500m.
Required:
a. If Bidder wishes to finance the acquisition with shares in the merged firm,
what is the maximum number of shares it would be willing to offer to
Targets shareholders? (5 marks)
b. What would be the consequences of such a bid on expected earnings per
share if we assume that the synergies will lead to an increase in expected
earnings of 200m in the first year? Does the effect on earnings per share of
the merged firm affect the merit of the transaction? (5 marks)
c. Instead of the share exchange, Bidder has sufficient surplus cash to finance
the acquisition with a cash offer. Alternatively, Bidder could return the
cash to its shareholders before making the bid and proceed with the share
exchange. How would you advise Bidder to decide between the share offer
and returning the cash to shareholders versus using the cash to finance the
acquisition? (7 marks)
d. Independently of the example above, what mechanisms do companies adopt
in an effort to prevent takeovers? Given that the targets shareholders
typically benefit from a takeover, can these takeover defences ever be
justified? (8 marks)
Reading for this question
Brealey et al. (2010), Chapter 32.
Subject guide, Chapters 5 and 10.
Approaching the question
This question tests candidates understanding of valuation in the context
of mergers and acquisitions.
a. Derivation of the maximum number of shares:
Target Bidder Merged firm
Number of shares outstanding 1,000 5,000 6,250
Expected EPS 0.5 3.2 2.512
PE ratio 10 2 2.4
Share price 5 6 6
MV 5,000 30,000 37,500
Value Bidder: 30,000m
Value Target: 5,000m
Value Synergies: 2,500m
Total: 37,500m
For the bidder not to lose, post-merger shares price has to be above
6, which implies a maximum of 6,250m shares, (37,500/6250 = 6)
21
AC3059 Financial management

or 1,250 extra shares. So, the maximum number of new shares that can
be offered is 1,250 shares for the 1,000 Target shares or 1.25 shares of
the bidder per target share. Alternatively NPV=0=MVTB MVT MVB
(xMVTB MVT) = 37.5(1 x) 30 so share of merged firm given
to Targets shareholders is x = 0.2. Again since share price must be
above 6, 20% of 6,250m shares is 1,250, which again is 1.25 shares in
merged firm per share in Target.
b. Effect on EPS:
Expected earnings of the new firm: New eps = [500 (Target) + 15,000
(Bidder) + 200 (Synergies)]/6,250= 2.512.
This is a decline in eps compared to Bidders current level. However,
this should not affect the decision making process of the bidder. If the
deal can be done for less than 1,250 new shares, the bidder creates
shareholder value.
c. Value of cash offer that again gives zero NPV for the merger is 7,500m.
So firm has 7,500m on its balance sheet. In deciding between
alternatives, many factors might play a role. Some of these are about
shareholder value maximisation. Others are not:
1. In a Modigliani-Miller world the two alternatives are the same, and
the firm should be indifferent between them.
2. Valuation of the shares: if the management of the firm feels the
shares are fairly valued or overvalued, it can go ahead and use the
shares to make an acquisition. If they are undervalued, then paying
cash is really cheaper from the perspective of long-term investors.
3. Control: if the bidder has a large shareholder, they may prefer to pay
cash rather than shares in order not to dilute the position of the large
shareholder.
4. Taxes: a cash bid would result in immediate tax consequences for the
shareholders of the target firm. Would they be willing to accept the
same premium in a cash bid as in a stock bid?
5. Capital structure: what will the capital structure of the new company
be in a cash bid versus a stock bid? And how does this compare to the
optimal capital structure?
d. Examples of Takeover Defenses (mechanisms):
1. Greenmail Bribe raider to go away with average premium = 16%
to bidder, which comes from existing shareholders wealth
2. File antitrust suit to block acquisition
3. Anti-takeovers amendments/Shark repellents such as:
i. Staggered terms for board of directors
ii. Super majority provisions
iii. Fair price amendments prevents two tier offers.
4. ESOPs Put votes in the hand of employees (for example, Polaroid)
5. Poison Pill by 1993, 64% of 1,000 largest corporations had poison
pills
6. Defensive Management Buyouts (White Knight)
7. Lock-up Sales.
Arguments for and against takeover defenses:
1. Bargaining power: managers extract more value from bidders;

22
Examiners commentaries 2012

2. Preservation of valuable long-term contracts;


3. Managerial myopia: managers would focus on long-term objectives
if they are protected from takeovers.
Evidence:
Stock price drops 1.3% on announcement of anti-takeover amendment.
Stock price drops 2% when poison pill is announced.
Stock price goes up when board has majority of outside directors.
Stock price goes down when board is controlled by insiders.

Section B
Answer ONE question from this section and not more than one further question.
(You are reminded that four questions in total are to be attempted with at least
two from Section A.)

Question 5
Critically evaluate the Capital Structure Irrelevance Theory originally proposed
by Modigliani and Miller. (25 marks)
Reading for this question
Brealey et al. (2010), Chapter 18.
Subject guide, Chapter 6.
Approaching the question
This question tests candidates understanding of MMs capital structure
irrelevancy proposition. While most candidates were able to provide some
assumptions behind the theory and explain what the theory was all about,
the question asked for a critical evaluation of the theory.
Brealey et al. (2010), Chapter 17, pp.44652 begins with an explanation
of the irrelevance of capital structure. The key points of Modigliani and
Millers arguments are summarised below:
Assumptions:
Capital markets are frictionless with no transaction costs.
Individuals and corporations can borrow and lend at the risk-free rate.
All firms are in the same risk class and all cash flow streams are
perpetuities (namely, no growth).
There is no taxation in the world (no corporate tax nor personal taxes).
There is no cost on bankruptcy (namely, debt is risk free).
Corporate insiders and outsiders share the same set of information
(namely, no signalling opportunities).
Managers always maximise shareholders wealth (namely, no agency
costs).
Under this setting where there are no taxes and capital markets are
functioning properly, Modigliani and Miller argue that it makes no
difference whether a firm or an individual shareholder borrows. The
market value of a company does not depend on its capital structure.
This is a highly unrealistic and restrictive set of assumptions. It could be
argued that all assumptions are violated. Furthermore, empirical evidence
obtained from large sample studies suggests that capital structure does
matter. For instance, repurchases of equity financed with issues of
debt are associated with positive cumulative abnormal returns around
announcement dates.
23
AC3059 Financial management

Question 6
Provide and critically discuss motivations for engaging in mergers and
acquisitions. (25 marks)
Reading for this question
Brealey et al. (2010), Chapter 32.
Subject guide, Chapter 10.
Approaching the question
An answer from a good candidate can take a number of different forms but
providing the major points have been included and well-rehearsed then
a good mark should be achieved. One would expect descriptions of the
three basic types of merger vertical, horizontal and conglomerate to be
given. Then the various motives and theories can be described and related
to the basic types, where appropriate, with a discussion and an example
if possible. The motives that one would expect to be included would be
a description of the synergistic effects of joining two firms together, for
example, economies of scale, economies (or diseconomies) of vertical
integration, benefits from the use of complimentary resources, eliminating
efficiencies (including poor management), improving market power,
access to surplus funds and/or unused tax shields, to diversify, maximise
shareholder wealth through bootstrapping or lowered financing costs,
taking advantage of undervalued shares in target company, behavioural
reasons such as managements need for power or status increase in the
new company for a successful manager, reduction of risk of takeover by an
unwanted predator, etc. A short discussion could also cover who the prime
movers for the merger are and why management? The personal rather
than general shareholder reasons could be investigated and discussed;
financial, behavioural, etc.

Question 7
Describe and discuss the relevance to the real world of the following theories of
dividend policy: Modigliani and Millers irrelevance theory, the dividend clientele
theory, agency cost theory, and signalling theory. (25 marks)
Reading for this question
Brealey et al. (2010), Chapter 17.
Subject guide, Chapter 7.
Approaching this question
This question tests candidates understanding of dividend policies. A good
answer should not only explain the relevant theories of dividend policy
but should also explain their relevance to the real world. The arguments
can be found in the subject guide.

Question 8
Identify five ratios which may be used to assess a firms performance as well as
its main determinants. Discuss the pertinence of ratio analysis when assessing a
firms performance. (25 marks)
Reading for this question
Brealey et al. (2010), Chapter 29.
Subject guide, Chapter 11.
Approaching the question
A good quality answer to this question should not just introduce five
financial ratios which the candidate thinks are appropriate but should
24
Examiners commentaries 2012

lay the foundations by first identifying the general limitations of ratio


analysis and what implications they may have when trying to assess the
ratios being used to measure a firms performance. There are quite a
number of limitations and a candidate is expected to know the majority.
The limitations include such points as the fact that the accounting
numbers are historical and may well be out of date; that there are
some differences in accounting definitions and techniques in principle
as well as between companies; there are differences over time due to
changes in both the economic and reporting environments; one may
not have appropriate standards for comparison, particularly bearing in
mind that short-run fluctuations may be hidden and that the numbers
from a balance sheet only reflect that one datum point. Accounts are
published documents and so their authors may want to include some
window dressing, or be economical in their notes to the accounts which
can exacerbate an analysts problems particularly when reviewing the
accounts of a diversified company. A final point worth making is that the
past as reflected in the accounts may not be a good predictor of the future.
Naturally an answer should include brief descriptions/definitions of
various ratios deemed to be appropriate such as a firms return on capital,
return on equity, return on asset and their determinants. These too should
come with comments and criticisms as well as descriptions. Finally, a very
good answer would mention that there are no successful statistical models
using these ratios to evaluate or predict profitability, only models for
predictions of bankruptcy or levels of creditworthiness.

Question 9
Corporate valuation techniques are the same whether valuation is required in
the context of mergers and acquisitions or by a private investor. Discuss.
(25 marks)
Reading for this question
Brealey et al. (2010), Chapter 32.
Subject guide, Chapters 9 and 10.
Approaching the question
A good answer would make it clear that the same corporate valuation
techniques may indeed be used both in the context of mergers and
acquisitions or by a private investor. Corporate finance analysts working
in mergers and acquisitions departments may however have different
information sets from private investors, which may have implications
for choices of valuation methods. Also, in the context of mergers and
acquisitions, one needs to consider the value of the target to the acquirer
(as well as to other potential acquirers) in addition to the value of the
target on a stand-alone basis.

25