UNIVERSITY COLLEGE LONDON

EXAMINATION FOR INTERNAL STUDENTS

MODULE CODE : MSIN0146

ASSESSMENT : MSIN0146A6UC
PATTERN

MODULE NAME : MSIN0146 - Financial Management

LEVEL: : Undergraduate

DATE : 25/08/2021

TIME : 10:00

This paper is suitable for candidates who attended classes for this
module in the following academic year(s):

Year
2020/21

Additional material

Special instructions

Exam paper word

count

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 MSIN0146 Financial Management
Level 6 LSA Examination Paper
2020/21

Examination length: TWENTY-FOUR (24) hours

Note: Although the window for completion is TWENTY-FOUR (24) hours, this exam paper
is designed to be completed in TWO (2) hours.

There are TWO (2) sections to the examination paper.

Section A consists of TWO (2) compulsory question and you should answer BOTH
questions. This section is worth FIFTY (50) marks.

Section B consists of THREE (3) questions and you should answer any TWO (2)
questions. Each question is worth TWENTY-FIVE (25) marks. If you answer more than two
questions in Section B only the first TWO (2) questions answered from Section B will be
marked.

In completing this paper, you should answer a TOTAL of FOUR (4) QUESTIONS
comprising: TWO (2) questions from Section A + TWO (2) questions from Section B.

Your submission should be typewritten in PDF format and be as one document.

You are advised to allocate your time between the two sections in proportion to the marks
available.
Discount tables are provided at the back of this exam paper if you need to use them.
Module Leader: Dr. George G. Namur
Internal Assessor: Pete Clark
 MSIN0146: Financial Management

SECTION A

This section consists of TWO (2) compulsory questions. Candidates should attempt BOTH
questions. This section is worth FIFTY (50) marks.

A.1 THIS QUESTION IS COMPULSORY

Benedict plc is a stock market-quoted UK company that specialises in researching and

developing new pharmaceutical compounds. It has two commercial operations. Through
one, it either sells or licenses its discoveries to larger companies. Through the other, it
operates a small manufacturing plant, selling output to pharmacies. Each commercial
operation accounts for about 50% of annual sales. The most recent statement of financial
position (balance sheet) for Benedict plc is given below.

Balance sheet as at 30 June 2021

£m £m £m £m
Non-current assets Non-current liabilities
Tangible at net book value 50 10% bonds at nominal value 40
Intangible at net book value 120 170
Current assets Current liabilities
Inventories (including work in 80 Trade payables (suppliers) 10
progress at balance sheet date)
Receivables (customers) 20 Bank overdraft 20 30
Bank 5 105
Total liabilities 70

Equity
Ordinary share capital (25p 100
nominal value)
Share premium account 50
Revenue reserves – reinvested 55
profits
Shareholders’ funds 205
Total assets 275 Total equity + liabilities 275

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 MSIN0146: Financial Management

Further information:

1) In the financial year to 30 June 2021, Benedict plc made total sales of £300 million,
with a 25% operating profit on sales margin (i.e. after depreciation but before tax and
interest).

2) The effective rate of corporation tax on operating profits is 20%, and this is likely to
remain unchanged for the foreseeable future.

3) The tangible non-current assets have recently been valued at a re-sale value of £65
million, although this value is not reflected on the balance sheet above.

4) Benedict plc depreciates tangible non-current assets at the rate of £5 million each
year. It amortizes intangibles at the rate of £10 million each year.

5) The bonds have a market value of £50 million.

6) It is anticipated that free cash flows will increase by 5% annually in each of the years
to the end of June 2022, 2023, and 2024. Thereafter it is assumed that the sales will
continue to grow at 5%. All sales are treated by the company as being cash sales.
The operating profit margin on sales should, in principle, remain at 25% for the
foreseeable future.

7) Work-in-progress within inventories represents 20% of inventories. It is development

work for a product for which no firm sales contract has been signed. A potential
customer has paid (15 months ago) for an option to purchase the product when
developed but has no obligation to proceed with that option. Benedict plc is of the
opinion that this potential customer will not proceed with any sales contract and the
work-in-progress will need to be written off immediately. Inventories which are not
work-in-progress are shown on the balance sheet at cost which is, when applying the
prudence principle, a realistic valuation.

8) The average PE ratio for quoted drug research companies at present is 22:1 and for
pharmaceutical manufacturers is 14:1. However, Benedict plc’s own PE ratio is 20:1.

9) The interest charge on the bank overdraft was 12% in the last financial year and will
remain at that rate in the current financial year to 30 June 2022 and beyond.

10) Annual investment in the replacement of non-current assets is £5 million. Assume

that no purchases of non-current assets qualify for capital allowances.

11) Over the foreseeable future, Benedict plc is anticipating no new projects.

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 MSIN0146: Financial Management

a) Determine the value of one ordinary share of Benedict plc using each of the following
methods:

(i) Net realisable value (6 marks)

(ii) PE ratio (4 marks)
(iii) Discounted free cash flows (using discount rate of 15%) (10 marks)

[20 marks]

b) Financial calculations are only part of the valuation process of a business, and there
are other factors which should be considered. Identify five (5) factors which should
be taken into account in valuing a business, and explain their significance.
[10 marks]

[TOTAL 30 MARKS]

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 MSIN0146: Financial Management

A.2 THIS QUESTION IS COMPULSORY

The directors of Redcliffe plc, a profitable, tax-paying stock exchange listed basic materials
and chemicals company, are debating the possibility of selling the business at some point in
the future, either to a competitor or a private equity firm. The idea came from the fact that
there seems to be consensus among directors that the market is undervaluing the shares of
Redcliffe plc.

The company is financed by a combination of ordinary shares and loan notes only.

At present the debt to equity ratio of Redcliffe plc is below the average of its stock
exchange listed competitors, likely because historically, the firm’s directors were always
risk-averse.

Worried that the low market valuation of Redcliffe plc will lead to a low bid from any
potential interested party (competitor or private equity firm), a board meeting has been
scheduled to discuss the matter of the current market valuation of Redcliffe plc, as well as
what may be done to ameliorate the situation.

In the course of the meeting, individual directors of Redcliffe plc have made the following
comments:

Director A: ‘As we have a good deal of cash on our balance sheet, the smart way to boost
our valuation would be to use most of that cash to buy back out debt. Not only would this
step boost our valuation, because it reduces the financial leverage and hence financial risk,
but it will probably make our company more attractive to a potential, whether a competitor
or a private equity company.’

Director B: ‘I believe that we should in fact borrow more money and use the proceeds to
buy back shares. As we are under-levered, this is one of the reasons, perhaps the main
reason, as to why our shares’ valuation is so low.’

Director C: ‘I understand the idea of the tax shield which would argue for ever more debt.
However, academic research showed that as a company such as ours borrows more, the
benefits of the tax shield are exactly offset by increased bankruptcy costs, making financial
gearing irrelevant to the value of the weighted average cost of capital.’

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 MSIN0146: Financial Management

Required:

Critique each of the three (3) comments, while clearly stating whether each director is
correct or not. Make a specific recommendation to the directors of Redcliffe plc about what
changes to make to the company’s capital structure, if any.
[20 marks]

[TOTAL 20 MARKS]

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 MSIN0146: Financial Management

SECTION B

This section consists of THREE (3) questions and you should answer any TWO (2)
questions. Each question is worth TWENTY-FIVE (25) marks. If you answer more than two
questions in Section B only the first TWO (2) questions answered from Section B will be
marked.

B.1

Carpenter plc has the following capital structure as at December 31st Year 4.

Ordinary shares 25p fully paid £80

General Reserve £36

Retained earnings £40.8

Total £156.8

Carpenter plc’s EBIT (earnings before interest and taxes) at the end of Year 4 was £64m and
the annual expected growth rate is 25%. The company is listed in the London Stock Exchange
and its shares are trading at £3.36 at the end of Year 4.

The company wishes to raise £115m to buy new machinery and a new commercial property
and is considering two alternatives: either make a one-for-five rights issue at a discount price
of £2.85 or to request a long-term loan, for which the bank is charging 10% annually.

If the first option is taken, it is expected that P/E will not change next year. If the second option
is chosen, P/E will fall 15% at the end of next year. Assume a tax rate of 25%.

Required:

a) Assuming the company issues rights, calculate the theoretical ex-rights price of an
ordinary share and the value of the rights for each original ordinary share. Show
your detailed workings.

[5 marks]

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 MSIN0146: Financial Management

b) Calculate the price of an ordinary share in Carpenter plc in one year assuming:
(i) The rights issue is made
(ii) A loan issue is made
Show your detailed workings. Comment on your findings.
[10 marks]

c) Explain the tax benefit from issuing a loan instead of the rights issue. Explain how
this tax benefit impacts a company valuation, and how that was reflected in your
findings in Part b) immediately above?

[7 marks]

d) In the context of raising capital, compare and contrast rights and bonus issues,
and explain which of the two would be more effective in a case similar to that of
Carpenter plc.

[3 marks]

[TOTAL 25 MARKS]

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 MSIN0146: Financial Management

B.2

Parts I and II are independent

Part I

Barney Ltd, a High Street retailer, has annual sales of £100m. All sales made by the
business are on credit, and bad debts amount to £600,000 a year.

On average, the settlement period for trade receivables is 80 days. Trade receivables are
financed by an overdraft bearing a 11 per cent rate of interest per year.

The business is currently reviewing a proposal from a factoring business, which offers to
advance 80 per cent of trade receivables (average settlement period of 30 days) at an
interest rate of 10%, in return for a fee of 2 per cent of total sales. The factor will collect the
trade receivables and pay the remaining 20 per cent of receivables to Barney Ltd when they
are received by the factoring business. In assessing the proposal, Barney Ltd believes that
the use of the factor will entirely eliminate bad debt, reduce the settlement period of
receivables from 80 to 30 days, and lead to credit administrative savings of £1,000,000.

Required:

Determine whether switching to the proposed factoring arrangement is advantageous to

Barney Ltd. Justify your answer. Show your detailed workings.

[10 marks]

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 MSIN0146: Financial Management

Part II

Casterbridge plc, a UK business is considering a major investment and it requires an

appropriate discount rate to use in a net present value assessment of it. A decision has
been made to use the business’s weighted average cost of capital (WACC).

This decision met with the disagreement of one of the finance department staff, who said:

‘Why should we use WACC? This investment will be financed out of retained profit, so the
equity cost of capital should be used. The cash which we raised from the loan finance was
spent years ago.’

Another member of staff disagreed and said:

‘It shouldn’t make any difference because our WACC should be equal to our equity cost of
capital. Or, at least, it would if the stock market functioned properly. It obviously doesn’t
function properly because it seems to ignore all that we do, no matter how much trouble we
take to publicize it.’

A dividend of £21 million was paid in respect of the year. Over recent years, dividends have
increased at the rate of about 9.4% a year. The general view in the business is that this rate
has been, and will continue to be, the target dividend growth rate.

Casterbridge plc’s statement of financial position (balance sheet) on 31 May 2021 shows
the following:

£ million
Non-current assets 443
Current assets 536
Total assets 979
Equity
Called up ordinary shares of £0.50 each 173
Retained profit 310
483
Non-current liabilities
5% loan notes 2024 (issued at par) 122
Current liabilities 374
Total equity and liabilities 979

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 MSIN0146: Financial Management

On 31 May 2021 the business’s share price was 165 pence and the 7% loan notes were
quoted at £92 (ex-interest) per £100 nominal.

The loan notes are redeemable at par on 31 May 2024. Both the dividend and the loan
notes interest for the year ended 31 May 2021 have already been paid.

The business pays corporation tax at the rate of 30%.

Required:

a) Determine the business’s WACC as of 31 May 2021.

[9 marks]

b) Discuss the comments made by the two members of the project’s finance
department staff, correcting and explaining any misunderstandings that they may
have. You should outline the appropriate theoretical arguments, where relevant.

[6 marks]

[TOTAL 15 MARKS]

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 MSIN0146: Financial Management

B.3

Polydata plc, an all-equity financed business, has developed a new type of data handling
device code named DHD27. Developing DHD27 cost £1 million. It is the business’s policy,
to write such expenditure off in equal instalments over the sales life of the product
developed, where the product is made and marketed.

If it is decided that DHD27 is commercially viable, production will start on 1 January 20X1,
the first day of the business’s accounting year. Sales revenues from DHD27 are estimated
as follows:

£m
20X1 4
20X2 8
20X3 8
20X4 4
It is estimated that variable costs of 30% of sales value will be incurred. Also incremental
fixed costs of £1 million per annum will be incurred.

Manufacture of DHD27 will require an investment of £4 million in additional plant. This

would be purchased and paid for on 31 December 20X0 and disposed of for an estimated
£1 million on 31 December 20X4, with the cash expected to be received on the same date.

For present purposes, assume that the plant would attract 25% (reducing balance) tax
allowance, in the year of its acquisitions and in every subsequent year of its being owned
by the business except the last year. In the last year, the difference between the plant’s
written down value for tax purposes and its disposal proceeds will either be allowed to the
business as an additional tax relief, if the disposal proceeds are less than the written down
value or be charged to the business if the disposal proceeds are more than the tax written
down value.

DHD27 would be expected to have an adverse effect on sales of one of the business’s
other products to the extent of 25% of the sales value of DHD27. The other product has
variable costs of 40% of its sales value. Any reduced sales volumes of the other product will
have no effect on any fixed costs.

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 MSIN0146: Financial Management

Working capital items required to support each set of annual sales would be involved with
DHD27 and the existing product as follows:
trade receivables 15% of sales revenue
inventories 20% of variable costs
trade payables 10% of variable costs

Working capital would need to be in place by the start of the year concerned. Changes in
working capital will not have any tax effect.

The directors are seeking a minimum return on capital of 15% per annum, after tax.

Assume a corporation tax rate of 30% with tax being paid at the end of the accounting year
to which it relates.

Required:

a) Prepare a schedule that shows the annual relevant net cash flows associated with a
decision to go into production with DHD27. Show your detailed workings.

[12 marks]

b) Using your findings in Part a) immediately above, recommend a decision on the basis
of the NPV rule.
[4 marks]

Part c) below is independent of Parts a) and b) immediately above.

c) You hear a financial consultant make the following three statements:

(i) ‘The objective of discounting future cash flows in investment appraisal is to

correct for the effects of inflation. Since future rates of inflation are expected
to be low, it is probably not worth bothering to discount anymore.’

(ii) ‘Net present value (NPV) is a flawed method of investment appraisal because
it completely fails to take account of depreciation of the non-current assets
associated with each project.’

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 MSIN0146: Financial Management

(iii) ‘NPV is incapable of helping with investments involving advanced

manufacturing technology, such as computer-aided manufacturing. It is much
better to gather together the data on such an investment opportunities and
make a more subjective judgement, based on strategic factors.’

Briefly comment on each of these three statements, while ensuring to point out
whether they are true or false.

[9 marks]

[TOTAL 25 MARKS]

END OF PAPER
MSIN0146: Financial Management