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MARKING SCHEME
EXAMINATION PAPER: ACADEMIC SESSION
2017/2018
Campus Greenwich and International Partners

Faculty Business

Department Accounting and Finance

Course Code FINA 1027

Course Title Finance

Level 6

Duration 3 HOURS

Date May 2018

Course co-ordinator: Dr. Patricia Ntozi-Obwale

INSTRUCTIONS TO CANDIDATES
Section A is compulsory. Answer Three (3) questions in Section B.

This is a CLOSED book examination.

Tables and formula sheets are attached to this question paper.

Non-programmable calculators are permitted.

Section A

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Question One: This is a compulsory question.

Background

Das Plc is a thriving supermarket that specialises in the production of South Asian food and
drink and has its headquarters in the UK. The business has fully established a chain of 20
supermarkets across major cities of the UK.

The company seeks to expand its business overseas. The Chief Financial Officer (CFO) has
proposed an expansion to Doaba; the original country from which the company imports its
produce. Das Plc is highly popular in the country of Doaba and has been recognised by the
Government for its ethical values. Das is known to pay its workers a fair wage and is
committed to its custom duty whilst exporting goods.

The Chief Executive Officer welcomes the idea of supplying its produce in Doaba however is
concerned about the increased competition against competitors, a problem that was almost
non-existent for Das in the UK market. The CFO has promised that the business will be able
to distinguish its product ethically by promoting Fairtrade and promises to provide top quality
produce.

Proposed Investment

The CFO’s projected cash flows from the project are presented in the chart in the local
currency of Daoba Rupees (₹):

Projected Sales in Doaba from year 1 to year 5 respectively

8 7.86
7.8
7.59
Millions of Rupees

7.6
7.45
7.4 7.32
7.2
7 6.95
6.8
6.6
6.4
Years

The exchange rate today is ₹81.00/£1.

Forecasted exchange rates are as follows:
Year 1 2 3 4 5
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₹ Rupees/£ 82 84 86 86 87

The project is estimated to cost ₹15 million for the initial set up. Capital allowances are
available on the initial investment in plant and machinery on a straight line basis at the rate of
25% per year. A further Initial investment of working capital of ₹500,000 would be financed
by a loan from a local bank, at an annual interest rate of 10%. The bank loan should be paid
off at the end of the 5 year period.

Das plc will remit all its profits to the UK at the end of each year. A double taxation treaty
exists between the UK and Doaba. Doaba tax is 25% while that in the UK is 30% after all
interest and capital allowances are removed. Both countries consider that tax is paid in the
year in which profits are made.

Project Evaluation
Das plc is currently reviewing the capital structure of its company to ensure that it minimises
its cost of capital (WACC). The financial information of the company as at 1 January 2018 is
as follows:

£000
Ordinary shares, £1 each 15,000
Reserves 10,000
7% preference shares, £1 each 10,000
10% irredeemable bonds 15,000
50,000

The current share price of Das Plc on the AIM stock exchange stands at £3.26. The company
has also recently paid out a dividend of 60 p for each share held with a growth rate of 3.5%.
Other sources of finance are preference shares and 10% coupon bonds. The preference shares
have a price of 95p while bonds are at £103.

a) Calculate Das’ Weighted Average Cost of Capital (WACC) (12 marks)

b) Compute the Net Present Value (NPV) of the 5-year project. (18 marks)

c) Discuss some of the advantages of the NPV investment appraisal method. (10 marks)

(Total Marks: 40)

(a)
Equity (Ke):
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Ke = ((0.60 × 1.035)/3.26) +0.035 = 22.5% (1 mark)

Preference Shares (Kp):

Kp = (0.07/ 0.95) x 100 = 7.4% (1 mark)

Irredeemable Bonds (Kd):

= (10 (1 – 0.30)) / 103
= 6.8% (2 mark)

Some students used 25% instead of 30% tax. I don’t penalise them and therefore give
full marks for irredeemable bonds:

b)
Weighted Average Cost of Capital = WACC

Market % cost
Source (000)- Value (₹'000) Cost (£'000)
  a) b) (a x b)
Equity (15,000 x £3.26) 48,900 22.5 11,026.95 (2 marks)
Preference (10,000 x
£0.95) 9,500 7.4 703 (2 marks)
Bonds(150 x £103) 15,450 6.8 1,050.6 (2 marks)
  73,850   12,779.6 (1 mark)

The WACC Calculation:

(£12,779.6/£73,850) *100 = 17.3% (1 mark)

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NPV calculation:

Capital allowances are straight line basis: 25% of 15 million initial investment
= ₹ 3.75 million
Interest of 10% of ₹500,000 = ₹ 50,000 Or ₹ 0.05m
marks
Year 0 1 2 3 4 5
Cashflow (₹ m) 6.95 7.32 7.45 7.59 7.86
Capital Allowances (CAs) (3.75) (3.75) (3.75) (3.75) (3.75) 1
Interest (₹ m) - 10% (0.05 (0
) .05) (0.05) (0.05) (0.05) 2
Taxable Profit 3.15 3.52 3.65 3.79 4.06 1
Doaba Tax 25% (0.79) (0.88) (0.91) (0.95) (1.02) 1
Profit after tax 2.36 2.64 2.74 2.84 3.04 1
Add back CAs 3.75 3.75 3.75 3.75 3.75 1
6.11 6.39 6.49 6.59 6.79
Initial Investment((₹ m ) (15)
Working Capital ((₹ m)- (0.5) 1
Loan 0.5 (0.5) 1
Project Cashflow (15) 6.11 6.39 6.49 6.59 6.29 1

Remitted to UK ((₹ m ) (15) 6.11 6.39 6.49 6.59 6.29

Exchange Rate ($ /£) 81 82 84 86 86 87
£M £M £M £M £M £M
Sterling Equivalent (£) (0.185) 0.074 0.076 0.075 0.077 0.072 2
(0.0020 (0.0022
UK tax to be paid ) (0.0021) (0.0021) ) (0.0023)
After tax cash flow (0.185) 0.072 0.074 0.073 0.075 0.070 1
discount factor –17%
mark) 1 0.855 0.731 0.624 0.534 0.456
Present Value (0.185) 0.062 0.054 0.046 0.04 0.031 1
(1 1
mark) NPV = £0.048m
This project has a positive NPV and 1
therefore is worth it

Double Taxation Calculation

Taxable Profit 3.15 3.52 3.65 3.79 4.06
Doaba Tax 25% (1 mark) (0.79) (0.88) (0.91) (0.95) (1.02)
UK tax 5% of profit (0.16) (0.18) (0.18) (0.19) (0.20) 1
Exchange rate 82 84 86 86 87
UK tax in £ 0.0020 0.0021 0.0021 0.0022 0.0023 1

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(c) Each point that is well explained gets 2 marks, A max of 10 marks
 Takes account of the time value of money
 Takes account of the amount and timing of cash flows
 Uses cash flows rather than accounting profit
 Takes account of all relevant cash flows over the life of the project
 Can take account of both conventional and non-conventional Cash flows
 Can take account of changes in discount rate during the life of the project
 Gives an absolute rather than a relative measure of the desirability of the
project
 Can be used to compare all investment projects.

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SECTION B

Answer any THREE questions from this section

Question Two

May plc has 10 million ordinary shares in issue and its current market price is £8.00 per share.
The company wishes to embark on a major expansion programme and, given its current high
level of financial gearing, has decided to raise new equity of £4 million.

The company is seeking your advice on a number of potential share issue methods:
(i) A rights issue at 25% discount to the current market price;
(ii) A deep discounted rights issue at 50% discount;
(iii) A placing of shares with institutions at 12 ½% discount to the current market price.

Required:

a) Calculate the theoretical ex rights price under options (i) and (ii) (8 marks)
b) An investor, Mr. Khan that owns 1000 shares is concerned that he will not be able to
buy shares in the rights issue given that he feels that he holds enough investment in
May plc shares and would like to diversify to another investment. Demonstrate to Mr.
Khan whether he will lose value if he does not buy shares in the rights issue and advise
him on the best possible outcome. Consider a scenario where the company chooses the
cheaper rights issue option of a deep discount. (5 marks)
c) Calculate the effect on Mr. Khan’s wealth if the company chooses to raise money
through a placing of shares under option (iii). (5 marks)
d) Comment on why UK insurance companies and pension funds may prefer companies,
in which they invest, to have rights issues rather than placings to raise new equity
capital. (2 mark)

[Total Marks: 20]

a) Option 1:
Rights issue price: £8 * 0.75 = £6 (1 mark)
£4m/ £6 = 0.66m shares
Number of rights = 10m / 0.66m shares = 15 (1 mark)
For every 15 shares an old holder had he has the right to get one additional share in
issue,

Theoretical rights price = (£8 * 15 shares) + (£6 * 1 share) / 16 = £7.875 (2 marks)

Option 2:
Deep discount:
Price of issue: £8 * 0.5 = £4 (1 mark)
£4m/ £4 = 1m shares
Number of rights = 10m :1m = 10 old shares to 1 new share. (1 mark)
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Theoretical rights price = (£8 * 10 shares) + (£4 * 1 share) / 11 = £7.636 (2 marks)

b) Initial wealth: £8 *1000 = £8000

Value of the right = £7.636 - £4 = £3.636 (1 mark)
Exercise the right:
Investor can buy 1000/ 10 new shares = 100 new shares
Cost of buying new shares = 100 * £4 = - £400
Value of shares after rights issue = 1100 * 7.636 = £8400
Net wealth = £8400 - £400 =£8000 (1 mark)

Sell rights
Cash from sale = 100 * 3.636 = £363.6 (1 mark)
Value of shares after rights issue = 1000 shares * 7.636 = 7636
Net wealth = £364 + 7636 = £8000 (1 mark)

Doing Nothing: Only gives 1000 shares *7.636 = 7636 as net wealth (1 mark)

The wealth effect when he sells rights or buys shares in the rights issue is all adding up to
£8000. However, he will lose out from doing nothing.

c) Under option (iii)

Issue price = 8* (1-0.125) = £7 (1 mark)
Will issue 4m/ £7 = 571,428.5 new shares (1 mark)
Share price after issue = (£80m + £4 m) / (10m + 0.5714285m) shares = 7.945
(1 mark)
Wealth of shareholder = 1000 *7.945 = £7,945 (1 mark)
A dilution from £8000 to £7,945 = £55 (1 mark)

d) A rights issue will avoid the dilution of wealth unlike the placing of shares.
(2 mark)

Question Three

Tepo Productions, a digital printing company, currently has 1.5 million 50p ordinary shares in
issue, which are listed on the Alternative Investment Market (AIM), where they are currently
priced at 150p. £1 million 7% debentures make up the remainder of the company’s capital
structure. The debentures, which are redeemable in exactly three years, are also quoted on
AIM. They are currently quoted at £105. The company does not have access to a quoted beta
factor for its shares but, from experience, you consider that shares in Tepo Productions are on
average about 15% more volatile than the market. The company pays tax at the rate of 25%.

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a) Calculate Tepo Productions weighted average cost of capital using market values
Assume that the current risk free rate of return is 3% and the market rate of return is
10% (10 marks)

b) Describe how the Dividend Valuation Model can be used to estimate a company’s cost
of capital. (2 marks)

c) What practical problems are associated with calculating the WACC (8 marks)

Cost of equity

Ke = Rf + β(Rm - Rf)
Ke = 3 + 1.15(10 -3) = 11.05% - 2marks

Cost of debt - 4 marks

Year Cash Flow Discount Factor PV Discount Factor PV

7% 5%
0 (105) 1.00 (105) 1.00 (105)
1 7 0.93 6.51 0.95 6.65
2 7 0.87 6.09 0.91 6.37
3 107 0.82 87.74 0.86 92.02
(4.66) .04

Yield = LR + {[NPVLR / (NPVLR - NPVHR] * (HR – LR)}

5+ .04 x2 = 5.17 %
.04+4.66

MV of equity = 1.5 m x £1.50 = £2.25m 0.5 mark

MV of debt = 1m x(105/100) = £1.05m 0.5 mark
Total £3.30m

11.05 x 2250 + 5.17(1-0.25) 1050

3300 3300 2 marks
7.534 + 1.234

WACC= 8.77% 1 mark

b) ½ mark for each point:

The Dividend Valuation Model is based upon the net present value of future cash flows to an
investor; both dividends and capital appreciation.
The discount factor used is the investors’ required rate of return.
The Dividend Valuation Model is based upon the premise that investors value their
investments based upon predicted future income in the form of dividends.
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It would, therefore, appear to be most applicable to situations where investors obtain the
majority of their return from dividends rather than share price growth.

c. Calculating the different elements of finance is not always easy, eg, certain securities may
be traded irregularly and it is difficult to determine a market price such as the ordinary shares
of a private company. A similar problem may also arise with obtaining the market value of
bonds, particularly convertible bonds.
Leasing can also present problems when trying to calculate the average cost of capital. Many
leases provide finance on a medium to long term basis and should therefore be included in the
cost of capital calculations, and it is often difficult to accurately determine the capital value of
lease payments.
Another complication can relate to debt where interest payments are the subject of swap
agreements with the main issue being whether the cost of capital of the debt should reflect the
interest rate when the loan was first raised or the interest rate agreed in the swap.
The accuracy of the calculated cost of capital depends very much on the reliability and
applicability of the various different models used.

Difficulties also arise when determining which sources of finance should be included in the
weighted average cost of capital (WACC).
The usual rule is that if finance is being used to fund the long term investments of a company
it should be included in the calculations, and short term financing arrangements such as trade
creditors would not be included.
However, if a short term method of finance, such as a bank overdraft, was being used on an
ongoing basis it could be argued that it is being used to finance long term assets and therefore
should be included in the weighted average cost calculations.
Another problem is deciding what weightings should be attached to each different source of
finance.

Difficulties in finding the market values of securities will also have an impact, through the
weightings on the cost of capital that are applied to the different sources of finance. Market
values are usually preferred to book values. However market values may be hard to find or in
the case of bank loans may simply not exist.
Additionally problems may be experienced by companies that have raised debt finance in
foreign currencies, as the value of these debts will have to be translated into sterling against
an often unpredictable foreign currency market.

The Weighted Average Cost of Capital (WACC) is not constant.

The WACC is not a static figure particularly as the average cost of capital will change as the
market values of the securities change, not only will the weightings change but also the costs
of the different sources of finance.
This usually means that the WACC should be recalculated frequently and this is an advisable
practice. 1.5 to 2 marks for each point fully explained

Question Four

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The following information provides the returns of Sonia plc shares and the market index
returns respectively over the last eight quarters:

Return on Sonia plc (%) Market Return (%)

Date
1st Quarter 2016 2.2 0.3
2nd Quarter 2016 -0.6 2.4
3rd Quarter 2016 1.9 -1.6
4th Quarter 2016 -0.3 3.4
1st Quarter 2017 2.4 2.9
2nd Quarter 2017 1.8 1.2
3rd Quarter 2017 4.1 0.1
4th Quarter 2017 -0.8 -0.4

Dividends of Sonia plc in the last five years have increased at a rate of 1%. The current
dividend on 7th October 2017 is 84p.

The rate of return of the risk-free rate is 0.9% and the correlation coefficient between the
shares of Sonia plc and the market is 0.2.

a) Calculate the required rate of return of Sonia plc using the Capital Asset Pricing Model
(CAPM) (12 marks)

b) Discuss the limitations of portfolio theory as an aid to investment decisions (8 marks)

Total 20 Marks

a)

Step 1: Calculate the mean Return

RR = 1.3375% (1 mark) as in calculation in table on next page

Rm= 1.0375% (1 mark)

Step 2: Calculate the standard deviation of returns on

firm and the Market

Return Mean Return Difference Square Divide by n

difference
2.2 1.3375 0.8625 0.74390625  
-0.6 1.3375 -1.9375 3.75390625  
1.9 1.3375 0.5625 0.31640625  
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-0.3 1.3375 -1.6375 2.68140625  

2.4 1.3375 1.0625 1.12890625  
1.8 1.3375 0.4625 0.21390625  
4.1 1.3375 2.7625 7.63140625  
-0.8 1.3375 -2.1375 4.56890625  
Average
21.03875 2.62984375
=1.3375    

sqrt of 2.6298 = 1.62

σR = 1.62 (3 marks)

Return Mean Return Difference Square Divide by n

difference
0.3 1.0375 -0.7375 0.54390625  
2.4 1.0375 1.3625 1.85640625  
-1.6 1.0375 -2.6375 6.95640625  
3.4 1.0375 2.3625 5.58140625  
2.9 1.0375 1.8625 3.46890625  
1.2 1.0375 0.1625 0.02640625  
0.1 1.0375 -0.9375 0.87890625  
-0.4 1.0375 -1.4375 2.06640625  
Average=
21.37875 2.67234375
1.0375    

sqrt of 2.672 = 1.63

σm = 1.63 (3 marks)

Step 3: Calculate the beta between firm and the

Market

2
βs = (σs σm ρs, m)/ σ m
= (1.62 × 1.63 x 0.2)/2.66 = 0.1985 (2 marks)

Step 4: Use CAPM to calculate the rate of Return on firm’s

Shares

E(Rs) = Rf + βs (Rm − Rf) = 0.9 + [0.1985 x (1.0375 – 0.9]

= 0.93% (2 marks)
(Total marks: 12)

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b) Each limitation that is well explained gets a mark.

limitations of portfolio theory:
 Assumption that investors are rational
 The assumption that investors have homogeneous expectations (that investors
have the same expectations)
 The assumption that there is no tax.
 the assumption that investors can borrow at the risk-free rate is unrealistic.
 Transaction costs deter investors from making changes to portfolios.
 The composition of the market portfolio is difficult to determine
 The fact that the market portfolio does not include all stocks in all capital
markets and therefore will always be limited.
 Securities are not divisible in practice.
 Expected risk and return of securities are only estimates and difficult to obtain.
 There are numerous choices from a wide variety of possibilities and therefore
one wonders how all these choices can be made.
How one can actually determine the utility function.

Question Five

Detailed information of a 10-year government bond is listed in the table below. As a financial
advisor you are considering to recommend to your clients whether to investment in this bond.

A 10-year government bond

Par value 100
Coupon rate 6.0%
Current yield to maturity 5.5%

Required:

(a) Explain why there is an inverse relationship between interest rates and bond
prices.
(3 marks)

(b) Explain two important determinants of return on a coupon bond.

(4 marks)

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(c) Calculate the market price of the 10-year bond above at the time of issue
(5 marks)

(d) Calculate the market price of the bond if the yield to maturity is reduced by
0.5% in one year’s time.
(5 marks)

(e) Based on (c) and (d), what will the total return of this bond be after one year’s
time?
(3 marks)
(Total 20 marks)

Question 5
a)
Higher interest rates reduce the present value of cash inflows associated with bond and hence
reduce its prices. (3 marks)

b)
The return on a coupon bond comes from two sources:
– The difference between the purchase price and the principal value.
– Periodic coupon payments
(4 marks)

c) the cumulative present value factor (the annuity factor)

[1-(1+r)^(-n)]/r

The annuity factor of 5.5% for 10 years

7.538

PV of coupon: 6*7.538
45.23 (2 marks)

PV of par value: 100/[(1.055)^10]

58.54 (2 marks)

Bond price: sum of the above two

103.77 (1 mark)

d)
reduce by 0.5% implies 5.5% -->5.0%

the cumulative present value factor (the annuity factor)

[1-(1+r)^(-n)]/r]
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The annuity factor of 5.0% for 9 years

7.108

PV of coupon: 6*7.108
42.65 (2 marks)

PV of par value: 100/[(1.050)^9]

64.46 (2 marks)

Bond price: sum of the above two

107.11 (1 mark)

e)

Total return:

(6+107.11-103.77)/ 103.77 (2 marks)

=9.0% (1 mark)

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Question Six

The following data comes from the financial statements of Umbrellas Ltd (a retail store) for
the year ended 31st December 2017.

Balance sheet

£ million £ million
Non –current assets
Tangible assets 5,500
Longrun investments 20 5520

Current assets
Inventory 620
Accounts Receivable 60
Investments- Short-term 55
Cash at Bank 32 767

Accounts payable within one year (1983)

Accounts payable after more than one year (9% debentures) (604)

3700

Equity and Reserves

Called up Share Capital ( 200 million ordinary shares) 120
Share Premium account 1380
Other reserves 40
Retained earnings 2160 3700

Earnings per share over the last thirteen years has grown from £0.30 to £2.10. Over the
same period the company has steadily increased the dividend payable from £0.20 to £0.80
per share. Umbrellas has also provided the following additional information:
 The total market value of the company’s shares as at 31st December 2017 was £7
billion.
 The average equity premium is currently 10%. The current risk free rate of return is
6% and Umbrellas’ beta is 0.7.
 The debentures are currently trading at £104.
 The balance sheet shows the nominal value of the debentures.
 The buildings are undervalued in the balance sheet by £50 million.
 It is expected that 20% of the accounts receivable shown in the balance sheet will be
 bad debts.
 It is estimated that £40 million of the inventory shown in the balance sheet will prove
to be unsaleable.
 The short-term investments have a current market value of £75 million.
 The average price earnings ratio for other similar supermarkets is currently 15.

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a) Calculate the value of Umbrellas Ltd using a net asset valuation method. 8 marks

b) Calculate the value of Umbrellas Ltd , using a price earnings based method. 3 marks

c)Explain three disadvantages for each of the methods in (a) and (b) above. 9 marks

a) Calculation of net asset value

Balance sheet 3700 1 mark
Add Building revaluation 50 1 mark
Add short term investment revaluation 20 1mark
70
3770 1 mark

Less Bad debts 12 1 mark

Less unsaleable stock 40 1 mark
52
3718 2 marks
Adjusted net asset value

b) Value using earnings based method 2.10 x 15 x 200 million = £6.3

billion 3 marks

c) Main Problems: Net asset value ratio

– Fixed asset values are usually based on current historic cost less
depreciation. Different depreciation methods result in different values
of fixed assets. Whatever method of depreciation, the book values are
unlikely to correspond to market values. Although companies do
revalue their assets periodically, this is a subjective exercise, often
undertaken by the directors themselves.
– Values of stock may not be reliable, especially if the accounts were
prepared some time ago. Companies often “window dress” their
accounts at year-end and stock values in some industries are often
outdated. Window dressing refers to any accounting adjustment to the
accounts to present a better financial position.
– Some accounts may be uncollectable. Provision should have been
made for bad and doubtful debts but the bidder should be wary of the
extent of this allowance.

Price: Earnings ratio:

– The earnings figure can be distorted by accounting policies.
– The current earnings may be untypically high or low and it may be
more appropriate to take the average earnings over the last few years.
– It is difficult in reality to find close substitutes i.e. companies which
produce the same product lines, serve the same markets and have
similar management capabilities.
– Companies have different potential for growth.

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1 mark for outlining 6 total disadvantages. Additional 3 marks if students fully

explained or provided examples.

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FINA 1027 Formulae Sheet

DIVIDEND MODELS
Constant dividend
Ke = Div
MV (Po)
Dividend Growth
Ke = D1 +g
MV (Po)
MV (Po) = D1/(ke – g)

Cost of Debt for an irredeemable bond

Kd = I(1-Tax)
MV
Weighted Average Cost of Capital

WACC = E x Ke + D x Kd (1 –T) + .............

E + D + …………

Standard Deviation
σx = √Σ((xi – x̄ )2pi)

Mean return & standard deviation for historic data n

Mean return , R̄=

∑
n

i=1
n
Ri
S tan dard deviation, σ=
√ ∑(Ri -
i=1
n
{ R̄ )2
¿

Standard Deviation: two asset portfolio

Capital Asset Pricing Model (CAPM)

rj = rf + ß(rm – rf)

Beta of a Security

βj = (σj σm ρjm)/σm2

Internal Rate of Return (IRR)

NPV LR
IRR = LR +
[
NPV LR - NPV HR
x (HR - LR )
]
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FINA1027
Page 19 of 21
Approved

May 2018
Finance – EXAM - Marking Scheme
FINA1027
Page 20 of 21
Approved

May 2018
Finance – EXAM - Marking Scheme
FINA1027
Page 21 of 21