BMAN23000

Original Duration - Two Hours

Formula Sheet provided

Normal Distribution Table provided

THE UNIVERSITY OF MANCHESTER

FOUNDATIONS OF FINANCE

May/June 2020

SECTION A to be completed via online multiple choice questionnaire

and
Answer ONE question from SECTION B
and
Answer ONE question from SECTION C

You have twenty-four hours to complete this examination, but it is expected that you spend no
more than three times the duration of the original examination completing it.

As this is an open book exam, you should not directly quote from lecture materials, internet
sources or other material. Every answer must be written in your own words to avoid
plagiarism.

In addition, please note:

1. All textual answers must be typed and not hand-written.
2. Any part of the exam that requires equations, mathematical workings or diagrams
may be completed either by:
a. using your software of choice, such as the Equation editor of Word or
Powerpoint. It is your responsibility to ensure that any such information is
clearly discernible, in English, and appropriately integrated into a single final
document, or
b. Alternatively, it is permissible to include equations, mathematical workings
or diagrams in the form of photographs. It is your responsibility to ensure that
these are of high quality, and appropriately integrated into a single final
document.

Where mathematical workings are required, you must provide a textual explanation of each
step, indicating what the equations are demonstrating and why they are performing that step.

Electronic calculators may be used in accordance with the University regulations

© The University of Manchester, 2020.

PTO

Page 1 of 5
 BMAN23000

SECTION A – (30 marks)

To be answered via online multiple choice questionnaire

SECTION B (35 marks)

Answer ONE question

Question 11 (answer all parts)

You are an equity analyst valuing Manchester plc and use a two-stage dividend
discount model to forecast its equity value. It is a growth company and currently pays
no dividends, as it reinvests all its retained earnings back into the business.

You forecast that it will pay an annual dividend for the first time in three years’ time
(t=3) of £5 per share, which you forecast will grow by 7% per year thereafter, up to and
including the dividend in ten years’ time (t = 10), in a high growth stage.

After this, you forecast that dividends will grow at 2% afterwards (forever), in a low
growth stage.

The cost of capital for Manchester plc. is 12% per annum.

a) Using the above information, work out what will be the equity value per share of the
perpetual stream of dividends in the low growth stage, evaluated in ten years’ time (at
t = 10) (10 marks)

b) Next, work out the present equity value per share of the perpetual stream of
dividends in the low growth stage, evaluated at the current time (t = 0) (5 marks)

c) Calculate the equity value per share of the dividends from the high growth stage,
evaluated in two years’ time (t = 2) (5 marks)

d) Calculate the present value per share of the company’s equity at the current time
(t = 0) (5 marks)

e) Suppose you now estimate that the company’s dividends will grow at 3% instead of
2% in the low growth stage. Recalculate the value per share of the company’s equity
at the current time (t = 0), and comment on the results. (10 marks)

(TOTAL 35 MARKS)

PTO

Page 2 of 5
 BMAN23000

Question 12 (answer all parts)

You are asked to compare the following securities: a treasury bill, FTSE100 (market
portfolio), JBond PLC (a utility company stock), Skyfall PLC (a high-tech company
stock) and Thunderball PLC (a counter-cyclical company stock). You have collected
annual prices of each of them and calculated the realized returns for 6 years. Realized
returns data are included in Table 1 below.

JBond Thunderball
year Treasury bill FTSE100 Skyfall PLC
PLC PLC
2014 2% -10% 5% -5% 16%
2015 2% 1% 7% 3% 5%
2016 1% 3% 9% 9% 3%
2017 1% 9% 10% 20% -10%
2018 1% 14% 12% 16% -16%
2019 1% 13% 7% 14% -11%

a) Calculate:

i. the excess return of each realized return for each security in Table 1;
(2 marks)

ii. the historical average excess returns and volatilities of each security,
using the excess returns in part ai). Briefly comment on the results
(6 marks)

b) Assuming that each historical average excess return is a good proxy of the
expected return of each security, using the information found in parts a), now
calculate the beta of each security. Briefly interpret the results. (6 marks)

c) Once you have calculated the required rate of return of each security using the
formula “beta x average excess return” with the information in part b), indicate
whether each security is undervalued or overvalued and explain why.
(6 marks)

d) Briefly discuss the ways you know to diversify a portfolio.

(6 marks)

e) As for the asset pricing models:

i. briefly describe the CAPM assumptions; (4 marks)

ii. describe what each of the following pairs of asset pricing models has in
common, and how they differ:
- CAPM and APT;
- CAPM and F-F-C (Fama-French-Carhart) model.
(5 marks)
(TOTAL 35 marks)
PTO

Page 3 of 5
 BMAN23000

SECTION C (35 marks)

Answer ONE question

Question 13 (answer all parts)

Reckitt Benckiser Group plc is a British consumer goods company. It is considering

the replacement of one of its existing machines with a new model. The existing
machine can be sold now for £8,000. The new machine costs £50,000 and will
generate free cash flows of £11,416.55 p.a. over the next 6 years. The corporate tax
rate is 35%. The new machine has average risk. Reckitt Benckiser’s debt-equity ratio
is 0.5 and it plans to maintain a constant debt-equity ratio. Reckitt Benckiser’s before-
tax cost of debt is 5.85% and its cost of equity is 13.10%.

a) Compute Reckitt Benckiser’s weighted average cost of capital.

(5 marks)

b) What is the NPV of the new machine and should Reckitt Benckiser replace the old
machine with the new one?
(10 marks)

c) The average debt-to-value ratio in the pharmaceutical industry is 20%. What would
Reckitt Benckiser’s cost of equity be if it took on the average amount of debt of its
industry at a cost of debt of 5%? Do this calculation assuming the company does
not pay taxes.
(10 marks)

d) Given the capital structure change in question c), Modigliani and Miller would argue
that according to their theory, Reckitt Benckiser’s WACC should decline because
its cost of equity capital has declined. Discuss.
(10 marks)

(TOTAL 35 marks)

PTO

Page 4 of 5
 BMAN23000

Question 14 (answer all parts)

a) What alternative uses has a firm for its cash?

(6 marks)

b) Describe the advantages and disadvantages of different kinds of debt.

(5 marks)

c) Explain the role of debt covenants.

(4 marks)

d) Tefifza Ltd is considering opening a small store. The initial outlay of this
investment is £150 million. The present value of the expected cash flows
from the store is £110 million. Then assume that Tefifza Ltd, by opening this
store, acquires the option to expand into a much larger store after 5 years.
The cost of the expansion will be £250 million, and the expansion will be
undertaken only if the PV of the cash flows exceeds £250 million. At present,
the PV of the expected cash flows from a large store are only £200 million.
The variance in the present value of the cash flows is 0.06. The risk-free
rate is 4%.

Calculate the value of the option to expand using the Black-Scholes model.
What is the Adjusted Present Value (APV) of this project? Clearly show your
workings and explain each step in your calculation.

(20 marks)

(TOTAL 35 marks)

END OF EXAMINATION PAPER

Page 5 of 5