HERIOT-WATT UNIVERSITY

FINANCE – AUGUST 2021

Section I

Case Studies

Question 1

Neptune is a stock market listed company in the UK. It is a parts supplier to the automotive
industry. Neptune has won a big new contract, which would require new investment by the
company. The new contract is in the same line of business, but it would require a sizeable
investment by the company.

The contract is expected to produce after-tax cash flows of £45 million per annum for five
years. The investment will need £135 million of financing. The company is considering
various mixes of financing, from 100% equity through to 65% equity and 35% debt financing.

The company can borrow at 7.5%. Whatever sum the company borrows for the project, it will
repay all the principal back to the end of year 5 in the one payment. Interest would be paid
annually on the outstanding principal.

It will cost Neptune to raise funds from the markets. Equity finance will have issue costs to
the company of 10% of whatever sum it raises. With debt finance the issue costs for
borrowing would be 5% of the sum raised. Neptune needs a net £135m to invest in the
project. The company tax rate is 25%.

Senior management have asked you to evaluate the attractiveness to shareholders (i.e.
wealth maximisation) of the two options: all-equity funding or 35% debt funding. They want
you to conduct the analysis using the Adjusted Present Value (APV) method.

With the debt funding proportion (i.e. 65% equity and 35% debt), the debt beta will be 0.32
and the equity beta will be 1.495. The risk-free rate of interest is 5.5% and the market risk
premium is 6%.

Required: Maximum Word Limit 1000 words

(a) Calculate the APV of the project if it was funded entirely with a new issue of equity.
(6 marks)

(b) Calculate the APV of the project if it was funded with 35% new debt and 65% new
equity. Comment on the suitability of the project under the different funding
arrangements.
(10 marks)

(c) Why should managers use the adjusted present value (APV) technique if they can
use the WACC/NPV method instead? What advantages does the APV have? Give
examples where it would be more useful than WACC/NPV.
(8 marks)

1
(d) Explain fully how the following are dealt with in the capital budgeting process:
inflation, working capital, sunk costs and cannibalisation, giving examples where you
can.
(6 marks)

Total 30 marks

2
Question 2 Maximum Word Limit 1000 words

(a) Lenders usually insert conditions when companies borrow from them. What types of
covenants are usual in debt contracts? Explain the role they play in debt and equity
financing.
(7 marks)

(b) Why might measures based on EBIT (earnings before interest and taxes) or EBITDA
be more useful than the price/earnings (P/E) ratio as bases for valuing companies
(i.e. stock market capitalisation/earnings, or total enterprise value/EBIT)? What might
be the disadvantages of using EBIT or EBITDA?
(7 marks)

(c) Financial distress inflicts direct and indirect costs on a company in difficulties. Explain
what these costs are. Which has more impact on the value of the company? Discuss
the nature of these costs and how they affect the company, giving examples where
possible. Explain how a company can try to get out of financial distress.
(9 marks)

(d) In what ways are operating gearing and financial gearing related and how does the
relationship help with the decision over an appropriate capital structure at a
company?
(7 marks)

Total 30 marks

3
 Section II

Short Questions

Maximum Word Limit 2000 words

1. In January 2021, Tesla Inc shares were priced at $860. The value of the company at
that stock price was $810 billion. The reported price earnings ratio TTM (Trailing
Twelve Month) ratio in the Financial Times at that date was 1,693. At the same date,
Volkswagen (VW) was worth €89 billion and had P/E (TTM) of 18.

In January 2021, 15 of the 25 investment analysts following Tesla had buy or hold
ratings on the stock and 10 had sell.

In finance terms, how can you justify Tesla’s stock price? It is a growth stock, but
how can you pay that price for growth?
(8 marks)

2. Discuss how the pricing inputs for the real options model differ from those for the
financial option as used in the Black–Scholes model? What are the key differences?
(8 marks)

3. What can go wrong with capital budgeting projects? Give an example of a project
that has gone badly wrong and discuss the reasons why it has failed (this can be a
project you have been involved with).
(8 marks)

4. The BP share price is 353p. The risk-free rate of interest is 2.5% and the volatility of
the stock is 40%. What is the call price of a 360p three-month option using the
Black–Scholes model?
(8 marks)

5. Palozzi will pay a dividend next year of 25p. Dividends are then expected to grow at
a rate of 15% per annum for three further years after that. The dividend will then grow
at 6% per annum for five years. After that (year 10 onwards) growth will slow to 2%
per annum, which will be assumed to be the dividend growth rate thereafter. The cost
of equity is 12%, the debt rate is 6% and the tax rate is 25%. Palozzi is 80% equity
financed. What is the share price today?
(8 marks)

Total 40 marks

END OF PAPER