AFE-5-FDW

FINANCE IN A DIGITAL WORLD

2022-23

Revision Material
for first 6 weeks of teaching programme
Contents Pages

Revision Session # 1 ……. 3 to 4

- Loan Capital (Seminar 4)
- Share Capital (Seminar 5)

Practice Questions for Revision Session # 1

- Part A: Bond Valuation/Bond Yield ……. 5 to 6
- Part B: Share Valuation ……. 6 to 7

Revision Session # 2 ……. 8 to 9

- Risk & Return (Seminar 6)
- Financial Markets & Institutions (Seminar 2)
- Financial Management Function (Seminar 1)

Practice Questions for Revision Session # 2

- Part A: Risk & Return ……. 10 to 11
- Part B: Financial Markets & Institutions ……. 11 to 12
Efficient Markets Hypothesis

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AFE-5-FDW FINANCE IN A DIGITAL WORLD

REVISION MATERIAL 2022-23 (first 6 weeks of teaching programme)

REVISION SESSION 1

LOAN CAPITAL – BOND VALUATION (SEMINAR 4)

SHARE CAPITAL – SHARE VALUATION (SEMINAR 5)

Question 1 Ana Fofana

Ana Fofana is reading about a new issue of six-year high-yield bonds announced by
Banco Corporation. The bonds carry an annual coupon of 5½% and are being issued at a
discount of 11% to their face value (i.e. nominal or par value) of £100 each. Ana, who
wants to estimate whether they are fairly priced, observes that bonds of similar
maturity have yields to maturity of 7.64%.

Ana has savings of £10 000 which she wants to invest for about six years in the
relatively safe medium of bonds rather than shares. She is attracted by the high yield on
the six-year Banco Corporation bond but, concerned about the risk, she is instead
considering whether to instead invest in three-year zero-coupon bonds of equivalent
credit rating, which are currently trading at a price of £80.50 per £100 nominal.

Required:

(a) Estimate the value of the six-year Banco Corporation bond on the basis of the yield
to maturity of other bonds of similar maturity. Does your answer indicate that the
yield offered on the Banco bond is more or less than the yield of other similar
bonds? What might be the main reason for the difference, if any?
(b) Calculate the yield to maturity of the six-year Banco Corporation bond on the basis
of its proposed issue price.
(c) How does the yield to maturity of the three-year zero-coupon bonds compare with
that of the six-year bonds? What does your answer tell you about the apparent
shape of the yield curve?
(d) Describe the three main theories that have been proposed to explain the shape of
the yield curve.
(e) What type of risk does Ana seem to be concerned about, and which direction of
interest rate movement would adversely affect her investment in high-yield bonds?
(f) “The values of outstanding bonds change whenever the market rates of interest
change. In general, short-term interest rates are more volatile than long-term
interest rates. Therefore, short-term bond prices are more sensitive to interest rate
changes than are long-term bond prices.” Is this statement true or false? Explain,
using a suitable example for illustration.

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Question 2 Montblanc
Montblanc Limited, an unquoted private company, wants to make an initial public
offering of shares. The company last paid a dividend of 18 pence per share, and intends
to inform prospective share investors that the dividend is likely to grow at a rate of
1½% per year for the foreseeable future.
To determine an appropriate issue price for its shares, Montblanc Limited has decided
to use the share price of a comparable quoted company called Rolf plc as a proxy to
estimate the rate of return that shareholders expect for this level of risk.
Rolf plc’s shares are currently trading at a market price of 621 pence. Rolf plc’s dividends
for the last six financial years have been as follows (in pence per share):
Year 2010 2011 2012 2013 2014 2015
Dividend per share 31 31 34 31 36 40
Required:
(a) Explain the constant growth Dividend Valuation Model of share valuation, defining
each term of the formula and showing how it is used. What are its main limitations
in the valuation of shares?
(b) Using the information given in the question, estimate the required rate of return of
Rolf plc’s shareholders.
(c) Using the rate of return you calculated in part (b), estimate the appropriate
subscription price for the new issue of shares by Montblanc Limited based on its
stated dividend policy.

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PRACTICE QUESTIONS (FOR SELF-STUDY AT HOME): REVISION SESSION 1

Revision Session 1 – Part A: Bond Valuation/Bond Yield

Question 3 (From “Foundations of Finance” by Keown, Martin & Petty)

Calculate the value of a bond that will mature in 14 years and has a $1,000 face value.
The coupon interest rate is 7% pa, and investors’ required rate of return is 10 percent.

Question 4 Ichabod Crane (Past Fundamentals of Finance exam question)

Mr. Ichabod Crane is reading about a new issue of seven-year bonds announced by
Sleepy Hollow Corporation. The bonds carry an annual coupon of 6½% and are being
issued at a discount of 10% to their face value of £100 each. Mr. Crane, who wants to
estimate whether the Sleepy Hollow bonds are fairly priced, observes that bonds of
similar maturity have yields to maturity of 8 percent.
Mr. Crane has savings of £10,000 which he proposes to invest for about seven years in
the relatively safe medium of bonds rather than shares. He is attracted by the
apparently high yield on the Sleepy Hollow bond but, concerned about interest risk
exposure, he is considering whether to instead invest in four-year zero coupon bonds of
equivalent credit rating, which are currently trading at a price of £75 per £100 nominal.
Required:
(a) Estimate the value of the Sleepy Hollow bond on the basis of the yield to maturity of
other bonds of similar maturity. Does your answer indicate that the redemption
yield offered on the Sleepy Hollow bond is more or less than the yield of other
similar bonds? What might be the reasons for the difference, if any?
(b) Calculate the yield to maturity of the seven-year Sleepy Hollow bond on the basis of
its proposed issue price.
(c) How does the yield to maturity of the four-year zero coupon bonds compare with
that of the ten-year bonds?
(d) What do the yields to maturity of the seven-year Sleepy Hollow bonds and the four-
year zero coupon bonds tell you about the apparent shape of the yield curve? Is the
yield curve always shaped this way?

Question 5 Haley Grey (Past Fundamentals of Finance exam question)

Haley Grey has learned about a new issue of 6-year bonds announced by Riggers plc.
The bonds carry an annual coupon of 4.2% and are being issued at a discount of 10% to
their face value of £100 each.
Haley wants to evaluate whether the bonds being issued by Riggers plc are fairly priced.
She has observed that other bonds of that maturity are trading in the market at a yield
to maturity of 5.61% per annum.
Haley wants to invest in the bond market, and she is attracted by the apparently good
yield on the Riggers bond – but she is also concerned about the impact of bond duration
on the value of her investment. She is therefore considering an alternative plan of
investing in 5-year zero coupon bonds of equivalent credit rating, which are currently
trading at a price of £75.90 per £100 nominal.

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Required:
a) Estimate the value of the Riggers bond (in nearest round pounds) on the basis of the
yield to maturity of other bonds of similar maturity. State whether your answer
indicates that the redemption yield offered on the Riggers bond is more or less than
the yield of other similar bonds, and comment on what you think might be the
important reasons for the difference.
b) Calculate the yield to maturity of the bond on the basis of its proposed issue price.
c) Explain the nature of the risk that Haley Grey is apparently concerned about.
d) Calculate the yield to maturity of the zero coupon bonds.

Question 6 Natalie Nash (Past Fundamentals of Finance exam question)

Natalie Nash is thinking of investing in Leon plc bonds which have 4 years remaining to
maturity. These bonds carry an annual coupon of 4.5% and are currently trading in the
market at a 3½% discount to their face value of £100.
Natalie has decided that it would not be worth investing in the Leon plc bonds unless
they give her a return – i.e. a yield to maturity - of at least 6% per annum.
As a possible alternative to the Leon plc bond, Natalie is considering investing in 6-year
zero coupon bonds of equivalent credit rating, which are currently trading at a price of
£67.50 per £100 nominal.
Required:
(a) Estimate the value of the Leon plc bond on the basis of the minimum yield of 6%
which Natalie requires, and state whether it would it be worthwhile for her to
invest in the bond.
(b) Calculate the yield to maturity of the Leon plc bond on the basis of its current
market price.
(c) Calculate the yield to maturity of the zero coupon bonds.
(d) Explain what the yield curve shows. Using a simple diagram, explain what the yields
to maturity of the 4-year Leon plc bonds and the 6-year zero coupon bonds tell us
about the shape of the yield curve.

Revision Session 1 – Part B: Share Valuation

Question 7 Silicon Wafer Company (from Van Horne & Wachowicz)

Silicon Wafer Co currently pays a dividend of $1 per share and has a share price of $20.
If this dividend was expected to grow at a 12 percent rate forever, what is the firm’s
expected, or required, return on equity using a dividend discount model approach?

Question 8 Cowie (From past Fundamentals of Finance exam question)

Cowie Limited, a small private company, is planning an issue of new shares to
prospective investors, and is trying to fix a suitable subscription price for the shares.
The Managing Director of Cowie Limited has decided to fix the company’s share issue
price on the basis of the share price of a quoted company called Bothy plc which is
engaged in the same line of activity. For this purpose he intends to use the constant
growth Dividend Valuation Model.
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The shares of Bothy plc are trading in the market at a price of 416 pence each, and the
company has just paid a dividend of 22 pence. Bothy plc’s profits have grown from £49
million 6 years ago to the present level of £62 million. The company maintains a
constant dividend payout ratio.
The last dividend paid by Cowie Limited was 13 pence, and the company has advised
prospective share investors that the dividend is expected to grow at a rate of 3% per
annum for the foreseeable future.
Required:
(a) Explain the constant growth Dividend Valuation Model of share valuation, defining
each term of the formula and showing how it is used.
(b) Discuss the main limitations of the Dividend Valuation Model in its practical use for
the valuation of shares.
(c) Using the information given in the THIRD paragraph of the question, estimate the
required rate of return of Bothy plc’s shareholders.
(d) Using the information in the LAST paragraph of the question, and the rate of return
you calculated in part (c), estimate the appropriate subscription price for the new
issue of shares by Cowie Limited.

Question 9 Hasp (From past Fundamentals of Finance exam question)

Hasp Limited, a private company, is planning an initial public offering (IPO) of shares to
raise additional equity capital for working capital investment. The company’s Finance
Officer is trying to fix a suitable subscription price for the shares and, to estimate an
appropriate cost of capital, Hasp’s Finance Officer has been advised to use, as a proxy,
the cost of equity of a quoted company engaged in the same line of activity. She has
chosen Staple plc as an appropriate proxy company for this purpose.
The shares of Staple plc are trading in the market at a price of 436 pence each, and
Staple plc has just paid a dividend of 31 pence. Staple plc’s profits have grown from £34
million 7 years ago to the present level of £65 million. The company maintains a
constant dividend payout ratio.
Hasp’s share subscription price is to be estimated using the following information:
• Hasp Limited earned a return on equity of 15% in the last year, and the rate of
return on equity is expected to continue at this level for the foreseeable future.
• The company maintains a constant dividend payout ratio of 60%.
• Hasp Limited last paid a dividend of 46 pence per share.
Required:
(a) Write down the Dividend Valuation Model (DVM) and discuss the main limitations
of the model in its practical use for the valuation of shares.
(b) Using the information given in the SECOND paragraph of the question, estimate the
required rate of return of Staple plc’s shareholders.
(c) Using the information in the LAST paragraph of the question, and the rate of return
you calculated in part (c), estimate the appropriate subscription price for the new
issue of shares by Hasp Limited.

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REVISION SESSION 2

RISK & RETURN (SEMINAR 6)

FINANCIAL MARKETS & INSTITUTIONS/EFFICENT MARKETS (SEMINAR 2)
FINANCIAL MANAGEMENT FUNCTION (SEMINAR 1)

Question 1 Fig & Gig

The returns on two assets Fig and Gig are expected to be as follows, depending on the
state of the economy:

Economy Probability Return on Fig Return on Gig

Booming 0.10 15% 25%
Stable 0.55 12% 17%
Recession 0.35 8% –10%
Required:
(a) Calculate the expected return and the risk (i.e. standard deviation) of each of the
assets Fig and Gig.
(b) Which of these two investments do you think would be preferred by a rational
investor?
(c) Calculate the coefficient of correlation between the two investments, and comment
on what it tells you about the extent to which investment risk could be reduced by
combining them in a portfolio.

Question 2 Role of financial markets/Market efficiency

(a) Briefly outline the major functions performed by the capital market and explain the
importance of each function for corporate financial management. How does pricing
or information efficiency assist the financial management function?
(b) Describe the efficient markets hypothesis and explain the differences between the
three forms of the hypothesis which have been distinguished.
(c) Company A has 2 million shares in issue and company B 6 million. On day 1 the
market value per share is £2.00 for A and £3.00 for B. On day 2, the management of B
decides, at a private meeting, to make a cash takeover bid for A at a price of £3.00
per share. The takeover will produce large operating savings with a value of £3.2
million. On day 4, B publicly announces an unconditional offer to purchase all shares
of A at a price of £3.00 per share with settlement on day 15. Details of the large
savings are not announced and are not public knowledge. On day 10, B announces
details of the savings which will be derived from the takeover.
Required:
Ignoring tax and the time value of money between days 1 and 15, and assuming the
details given are the only factors having an impact on the share prices of A and B,
determine the day 2, day 4 and day 10 share prices of A and B if the market is:
1. Semi-strong form efficient
2. Strong form efficient

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Question 3 Role of financial management/Agency conflict

(a) “The most widely accepted objective of the firm is to make the most efficient use of
the firm’s resources and thereby maximise the value of the firm for its owners; that
is, to maximize shareholder wealth”. (Moyer, McGuigan & Rao – Contemporary
Financial Management, 2018).
Discuss why the theory of finance considers maximization of shareholder wealth to
be the underlying goal of a business firm, and why this theory gives greater
importance to the firm’s shareholders than to its other stakeholders?

(b) Explain what is meant by the "agency problem" between the shareholders of a firm
and its managers, giving examples of how such problems could arise, and
suggesting ways in which these problems could be minimised. (Where relevant,
refer to the given case of Mann Limited).

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PRACTICE QUESTIONS (FOR SELF-STUDY AT HOME): REVISION SESSION 2
Revision Session 2 – Part A: Risk & Return

Question 4 Stocks X & Y

Calculate the expected returns and standard deviations for Stocks X and Y for the given
states of the economy:

State of Economy Probability Rate of Return

Stock X Stock Y
Boom 10% 12.1% 20%
Normal 60% 6% 16%
Recession 30% 5% -4%
The coefficient of correlation between X and Y based on the above information is 0.54
Required:
(a) Calculate the expected return and standard deviation of Stocks X and Y.
(b) Calculate the coefficient of correlation between stocks X and Y.

Question 5 Addie & Baddie

The following table shows the rate of return for two assets Addie and Baddie for the
given states of economy.
State of Economy Probability of State of Economy Rate of return
Addie Baddie
Recession 0.2 8% –10%
Normal 0.4 10% 15%
Boom 0.4 13% 25%

Required:
(a) If you have £1,000 and you want to invest £600 in Addie and the rest in Baddie,
calculate the expected return and the standard deviation for the portfolio.
(b) Calculate the coefficient of correlation between assets Addie and Baddie.

Question 6 Warren Gates

Warren Gates is considering an investment in two stocks, Yeo and Zeo. As a friend had
advised him that investing in a single stock would be too risky, he wants to invest in a
portfolio of both shares. Warren is trying to evaluate how he could construct a portfolio
of the two stocks and. To aid his evaluation, he has obtained the following information
about the estimated likely rates of return of the two stocks in different states of the
economy, together with the estimated probability of each of these states:
State of Economy Probability Rate of Return
Stock Yeo Stock Zeo
Boom 20% 18% 19%
Normal 50% 6% 5%
Recession 30% 3% -9%

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Before proceeding, Warren wants to clarify his understanding of how investing in two
shares rather than one might reduce the risk of his investment. As you are a business
school graduate, he has asked you to explain how risk and return are calculated in
portfolio theory, and how investment risk gets reduced by portfolio diversification.
Required:
(a) Calculate the expected return and standard deviation of each of stocks Yeo and Zeo.
(b) Calculate the coefficient of correlation between Yeo and Zeo.

Revision Session 2 – Part B: Financial Markets/Institutions; Efficient Markets Hypothesis

Question 7 Pike & Minnow (Past exam question)
Pike plc has 400 million shares in issue as on 22nd April 2012, selling at a market price of
250p. Another company, Minnow plc, has 200 million shares in issue, the market price of
each being 130p. On 23rd April Pike’s management decide, at a private meeting, to take over
Minnow with a cash purchase at a price of 150p per share. The acquisition is expected to
create economies of scale resulting from horizontal integration, which would generate
additional cash flows with a net present value of £200m.
On 30th April Pike holds a press conference to announce that it intends to buy all Minnow’s
shares at a price of 150p. On 7th May Pike holds another press conference to announce the
additional cash flows which are expected to be generated as a result of the takeover.
Assume that the above are the only factors influencing the share prices of Pike and Minnow
between 22nd April and 7th May. Ignore tax and other implications.
Required:
(a) Assuming that the market is "semi-strong form" efficient, determine the share prices of
Pike and Minnow on 23rd April, 30th April and 7th May 2012.
(b) Explain the difference between "semi-strong form" and the other two forms of stock
market efficiency.
(c) Discuss the main implications of capital market efficiency for the financial manager.
(d) Explain the main economic functions served by the capital market and the financial
intermediaries that operate in it.

Question 8 Hawk & Vole (Past Fundamentals of Finance exam question)

Hawk plc has 10 million shares in issue as on 1st May 2018, selling at a price of 350p. Another
company, Vole plc, has 5 million shares in issue, the market price of each being 160p.
On 2nd May Hawk’s management decide, at a private meeting, to take over Vole with a cash
purchase at a price of 200p per share. The acquisition is expected to create economies of
scale which would generate additional cash flows with a net present value of £1.9 million.
On 9th May Hawk holds a press conference to announce that it intends to buy all Vole’s
shares at a price of 200p.
On 16th May Hawk holds another press conference to announce details of the additional cash
flows which are expected to be generated as a result of the takeover.

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Assume that the foregoing particulars are the only factors influencing the share prices of
Hawk and Vole between 1st May and 16th May. Ignore tax and other implications.

Required:

(a) Assuming that the market is "semi-strong form" efficient, determine the share prices of
Hawk and Vole on 2nd May, 9th May and 16th May 2018.
(b) Explain the difference between "semi-strong form" and the other two forms of stock
market efficiency.
(c) Discuss the main implications of the Efficient Markets Hypothesis for financial
managers.
(d) Explain the main economic functions served by the capital market and the financial
intermediaries that operate in it.

Question 9 Venus & Bugsy (Past Fundamentals of Finance exam question)

Venus plc has 80 million shares in issue on 1 May 2022, selling at a market price of 560p.
Another company, Bugsy plc, has 36 million shares in issue, the market price of each being
200p.
On 2nd May Venus plc’s management decide, at a private meeting, to take over Bugsy plc
with a cash purchase at a price of 240 pence per share. The acquisition is expected to
create extra value through managerial and other synergies which would generate
additional cash flows with an estimated net present value of £20 million.
On 9th May Venus plc holds a press conference to announce that it intends to buy all Bugsy
plc’s shares at a price of 240 pence per share.
On 15th May Venus plc holds another press conference to announce details of the
additional cash flows which are expected to be generated as a result of the takeover.
Assume that the foregoing particulars are the only factors influencing the share prices of
Venus plc and Bugsy plc between 1st May and 15th May. Ignore tax and other implications.
Required:
(a) Assuming that the market is "semi-strong form" efficient, determine the share prices of
Venus plc and Bugsy plc on 2nd May, 9th May and 15th May 2022.
(b) Explain the difference between "semi-strong form" and the other two forms of stock
market efficiency.
(c) Discuss the main implications of capital market efficiency for the financial manager.
(d) Explain the main economic functions served by the capital market and the financial
intermediaries that operate in it.

Revision Session 2 – Part C: Financial Management Function

[No practice questions provided – please revise the suggested solutions to Q3 of Revision
Session 2, and do necessary wider reading]

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