Strathclyde Graduate School of Business

Master of Business Administration

FINANCE AND FINANCIAL MANAGEMENT

March 2018 (2 hours)

Answer any THREE Questions

Calculators must not be used to store text and/or formulae nor be capable of
communication. Invigilators may require calculators to be reset. All answers are to be written in ink.
Failure to follow these requirements will lead to a deduction of marks.

To Be Issued: Discount Tables

SOLUTIONS

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Question 1

a) The management of Ultra Ltd. is attempting to price a new product. The expenditure on
machinery required to produce the product will cost £1,400,000. Determine the equivalent
annual cost of the machinery if the machinery has a working life of four years, that is to say
the cost of the machinery over four years if the cost of capital is 14 per cent.
(10 marks)

b) A company is negotiating a long term loan of £40 million, the interest rate on the loan will
be 8 per cent and the loan will be repaid in 6 equal instalments, with the first instalment
being due at the end of year three. Interest will be charged on the outstanding balance of
the loan and will be accumulated for the first two years when no re-payments will be made.
Determine the annual instalment required to repay the loan.
(10 marks)
V2 = 40,000,000 x FVF2/0.08
= 40,000,000 x 1.664 = 46,656,000

Repayments = Loan/PVAF6/0.08
= 46,656,000/4.6229
= 10.092411m

c) Your pension fund advisor has proposed that you contribute £5,000 per annum to a fund
offering a return of 7 per cent per annum for the next 10 years and then contribute £8,000
per annum for the subsequent 20 years until your retirement thirty years from now.
Determine the expected value of the fund after 30 years if this proposal is implemented.
(10 1/ 3marks)
V(30)=5000 x FVAF (30/0.07)+3000 x FVAF (20/0.07)
V(30)=5000 x 94.4608 + 3000 x 40.9955 = 595290
(TOTAL 33 1/3 MARKS)

Question 2
a) Braehead plc has grown steadily in recent years. Its current share price is £6.0 is consistent
with the constant rate of growth of dividend model, and dividends are expected to grow at
5 per cent per annum. If the required rate of return is 15 per cent determine the expected
dividend yield and the share price next year.
(10 marks)

P0=D1/(r-g) implies r=D1/P0 + g so that D1/P0=0.1

P1=P0(1+g)=£6x (1+.05)=£6.3

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b) Boxy plc’s share price is also consistent with the constant rate of growth of dividend model,.
The company’s expected earnings per share for the next year is £4.00 and it is anticipated
that it will maintain its long standing policy of retaining 40 per cent of earnings and
distributing the other 60 per cent in the form of dividends. If the required rate of return on
the shares is 16 per cent and the growth rate is 8 per cent determine the share price and
the proportion of the share price accounted for by the company’s growth opportunities.
(10 marks)
1 1
P0  2.40  £30.00 P(No growth)  4.00  £25.00
0.16  0.08 0.16

c) What insights do valuation models provide for the identification of the determinants of
price earnings ratios?
(10 marks)
(TOTAL 33 1/3 MARKS)

Question 3
Clyach plc has grown rapidly in recent years, to a large extent by expanding its product range. It
is now necessary to evaluate another new product investment. The latest of these products has
just completed the final stages of its trials and a decision must now be taken whether or not to
proceed to the manufacture of the product. The product’s development has already cost
£400,000 and the manufacture of the product will require an outlay of £1,500,000 on production
facilities. This expenditure will have to be depreciated for tax purposes on a straight line basis
over a ten year period, but the anticipated commercial life of product, given the level of product
innovation in the industry, is only five years. The residual (re-sale) value of the production line is
expected to be £250,000. The production line would be located in one of the company’s existing
factories with unused capacity. Based on the space occupied a cost of £40,000 will be allocated
to be product by the company’s management accounting system. The product is expected to sell
for £35.00 per unit and sales of 80,000 units are anticipated for the first year. For years two to
five 90,000 units are expected to be sold. The estimated variable cost per unit is £27.00 per unit,
made up of 50 per cent raw material costs and 50 per cent labour costs. The fixed costs of
production directly related to the product are expected to £100,000 per annum. Each product is
also allocated an overhead charge of 8 per cent of lower costs through the management
accounting system to allow for the recovery of R&D expenditure and head office expenses. It will
be necessary to hold the equivalent of 15 per cent of expected sales in stocks of the finished
product. Promotion and marketing expenditure prior to the introduction of the product will cost
£70,000 and a further expenditure of £20,000 per annum will be required for each of the next
five years. The company requires an expected return of 14 per cent on investments and pays tax
at 30 per cent.

a) Determine the net present value of the investment. Set out your calculations clearly and
specify the critical assumptions.
(20 1/3 marks)
Profit and Loss Account
0 1 2 3 4 5
Revenues 2800 3150 3150 3150 3150
Labour costs -880 -990 -1100 -1210 -1320
Materials/components -880 -990 -1100 -1210 -1320
Fixed Costs -100 -100 -100 -100 -100
Marketing costs -70 -20 -20 -20 -20 -20
Capital Allowances -80 -80 -80 -80 -80

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 Capital Gain/Loss -300

Profit   840 970 750 530 10

Tax -252 -291 -225 -159 -3
Net Cash Flow Statement
0 1 2 3 4 5
Revenues 2800 3150 3150 3150 3150
Labour costs -880 -990 -1100 -1210 -1320
Materials/components -880 -990 -1100 -1210 -1320
Fixed costs -100 -100 -100 -100 -100
Marketing costs -70 -20 -20 -20 -20 -20
Investment -1500
Resale Value 100
Working Capital -220 -28 248
Tax -252 -291 -225 -159 -3
NCF -1790 641 759 605 451 735
PVF (15%) 1.0000 0.8772 0.7695 0.6750 0.5921 0.5194
PV -1790 562 584 408 267 381
NPV 413
IRR 0.23
(3 marks)
b) Explain that is meant by sensitivity analysis, determine and discuss the sensitivity of the
investment’s NPV to deviations in the expected price from the assumed value of £35 per
unit.
(10 marks)

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 Sensitivity analysis- 10 per cent fall in price
Profit and Loss Account
0 1 2 3 4 5
Revenues 2520 2835 2835 2835 2835
Labour costs -880 -1100 -1100 -1210 -1320
Materials/components -880 -990 -1100 -1210 -1320
Fixed Costs -100 -100 -100 -100 -100
Marketing costs -70 -20 -20 -20 -20 -20
Capital Allowances -80 -80 -80 -80 -80
Capital Gain/Loss -300

Profit   560 545 435 215 -305

Tax -168 -164 -131 -65 92
Net Cash Flow Statement
0 1 2 3 4 5
Revenues 2520 2835 2835 2835 2835
Labour costs -880 -1100 -1100 -1210 -1320
Materials/components -880 -990 -1100 -1210 -1320
Fixed costs -100 -100 -100 -100 -100
Marketing costs -70 -20 -20 -20 -20 -20
Investment -1500
Resale Value 100
Working Capital -220 -28 248
Tax -168 -164 -131 -65 92
NCF -1790 445 462 385 231 514
PVF (15%) 1.0000 0.8772 0.7695 0.6750 0.5921 0.5194
PV -1790 390 355 260 136 267
NPV -382
IRR 0.05
(TOTAL 33 1/3 MARKS)

Question 4
Amroath plc found it necessary over the last two years to increase its level of bank borrowing as its
profitability fell and it encountered cash flow problems. Loans were arranged on a short term basis
and the company’s bank is now putting pressure on the company’s management to reduce its level
of debt. To enable it to reduce its debt Ambroath’s board of directors has decided to raise
additional capital by undertaking a rights issue. The company has decided to raise £270 million. It
has 250 million shares outstanding and these are currently trading at £3.00 per share. It is
anticipated that the announcement of the rights issue will lead to a fall in the share price. The
company has previously indicated that it would be possible to reduce its debt, utilising cash
generated internally by the business. The company’s investment bank anticipates that the share
price will fall by between 10 to 20 per cent on the announcement. As a result it has been decided to
make the rights issue at a relatively high discount of 40 per cent to accommodate the expected fall
in price.

a) Based on the pre-announcement price for the company’s shares determine the terms of the
issue, ex-rights price and the value of a right.
(15 marks)

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 Ps = £3.00(1 – 0.40) = £1.80

ΔN = £270m/£1.80 = 150m

Terms = 150m for 250m or 3 for 5

Px = £3.00 (250/400) + 1.80 (150/400) = £2.55

V(R) = Px – Ps = £2.55 - £1.80 = £0.75

b) Continuing to utilise the pre-announcement price demonstrate that an investor with 1000
shares will be equally well off by investing in the issue as he or she would be from selling the
rights.
(12 marks)
Initial investment 1000 shares at £3.00 £3000
Purchase of shares 600 shares at £1.80 £1080
Overall investment £4,080
Value of investment at Px 1600 shares at £2.55 £4,080
Change in wealth 0

Initial investment 1000 shares at £3.00 £3000

Sale of rights 600 rights at £0.75 £450
Remaining investment £2550
Value of investment at Px 1000 shares at £2.55 £2550
Change in wealth 0

c) If the share price falls by 20 per cent following the announcement of the rights issue at a 40
per cent discount to the pre-announcement price determine a revised value for the ex-rights
price and a right.
(6 1/3 marks)
Px = £2.40 (250/400) +£ 1.80(150/400) = £2.175
V(R) = £2.175 - £1.80 = £0.375

(TOTAL 33 1/3 MARKS)

Question 5
a) The expected return on Security A is 14 per cent with a standard deviation of 20 per cent and
the expected return on Security B is 18 per cent with a standard deviation of 30 per cent.
Determine the expected return and risk for a portfolio made up of 50 per cent of A and 50 per
cent of B if the correlation coefficient for the returns on the two securities is i) +1.0, ii) +0.40, iii)
0 and iv) -1.0 and comment on your results.
(10 marks)
E(Rp) = 0.5 x 14 + 0.5 x 18 = 16.0
i) VAR(RP) = 0.52 x 202 + 0.52 x 302 + 2 x 0.5 x 0.5 x 1.0 x 20 x 30
= 625
SD(Rp) = √625 = 25.00
ii) SD (Rp) = 21.10
iii) SD (Rp) = 18.03
iv) SD (Rp) = 5.0

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b) The average security has an expected return of 15 per cent and the variance of the return is
260.

i. Determine the variance of an equally weighted portfolio of 2, 10 and 30 securities if

returns are independent and comment briefly on your results.
(5 marks)
VAR(Rp) = 1/N AV∙VAR
N=2 1/2 x 260 = 130.0
N = 10 1/10 x 260 = 26.0
N = 30 1/30 x 260 = 8.67

ii. Determine the variance of equally weighted portfolios of 2, 20 and 40 securities if the
typical co-variance is 120 and briefly discuss your results.
(10 marks)
VAR(Rp) = 1/N AV∙VAR + (1 – 1/N) AV∙COV
N = 2 = 1/2 x 260 + 0.50 x 120 = 190
N = 10 = 1/10 x 260 + 0.90 x 120 = 134
N = 30 = 1/30 x 260 +0.967 x 120 = 125

c) Explain the results of empirical studies that consider the implications for the risk of a portfolio
as the number of securities in the portfolio is increased, the securities being chosen on a
random basis.
(10 1/3 marks)

(TOTAL 33 1/3 MARKS)

Question 6
a) Explain what is meant by a call option, develop a profit diagram for a call to illustrate the
possible outcomes for an investment in a call, and discuss the possible reasons for investing in a
call.
(10 marks)

b) Discuss the factors likely to influence the market value of a call.

(10 marks)

c) Discuss the nature of a straddle and the rationale for an investor adopting such an
investment strategy.
(10 1/3 marks)
(TOTAL 50 MARKS)
End of Paper

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 Some Equations

Capital Market Line

E(RP )  RF 
 E(R)  RF 
M
SD(RP )
SD(RM )

Security Market Line (CAPM)

E(Ri )  RF   E(RM )  RF  βi

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