Examiners’ commentaries 2022

Examiners’ commentaries 2022

AC3059 Financial management

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of the course and having completed the essential reading and activities, you should be
able to:

describe how different financial markets function

estimate the value of different financial instruments (including stocks and bonds)
make capital budgeting decisions under both certainty and uncertainty
apply the capital assets pricing model in practical scenarios
discuss the capital structure theory and dividend policy of a firm
estimate the value of derivatives and advise management how to use derivatives in risk
management and capital budgeting
describe and assess how companies manage working capital and short-term financing
discuss the main motives and implications of mergers and acquisitions
integrate subject matter studied on related modules and to demonstrate the
multi-disciplinary aspect of practical financial management problems
use academic theory and research to question established financial theories
be more proficient in researching materials on the internet and Online Library
use Excel for statistical analysis.

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AC3059 Financial management

What the examiners are looking for

The examination paper has two sections, A and B, with six questions in Section A and two in
Section B. Candidates should answer four questions from Section A and one from Section B. All
questions carry equal marks.

Section A has the analytical and computational questions that test your ability to apply analytical
and computational skills to the problems set, and then they usually conclude with a part requiring
interpretation of the solutions prepared in the first parts of the question. The questions in Section B
usually require a mix of understanding, knowledge, description or analysis and application applied to
the theory, concept or practical scenario presented. The answer should then be presented in an essay
format, unless otherwise requested.

Workings should be submitted for all questions requiring calculations. Any necessary assumptions
introduced in answering a question are to be clearly stated.

The problem-based questions in Section A are quite lengthy and to speed up your understanding
and analysis of what each question is about, we suggest that first you go to the end of each question
and read the requirements for that question before reading the text in the body of the question.
This approach saves you time that otherwise would have been spent reading information for a
question that you are not going to attempt, since you can decide whether or not to attempt a
question once you have read its requirements. If you are not going to attempt a particular question,
then you have not wasted time reading information that you do not need to read.

The second benefit is that, having read the requirements for a question you are going to attempt,
you can then go on and read the whole question with an idea of what information you expect to be
looking for in order to answer the question set.

Wherever a written answer is required, be it a whole answer or just part of the answer, you will be
expected to produce an answer which presents and develops the theory(ies) and concept(s) that are
appropriate, and then to sustain your argument in the context of the question set. If a judgment is
required, then it should be demonstrated in the light of the argument you have presented for the
context given to you. The length of your answer should reflect the maximum marks that can be
awarded to your answer. Do not write page after page to answer a question that is only worth, say,
five marks maximum, since you should not spend more than nine minutes on such an answer. If you
have spent more time on the five-mark answer, you are reducing the time you could spend earning
marks elsewhere. Remember that spending more than a quarter of the examination time on one or
more questions can seriously reduce your chances on the other question(s) you want to tackle.

In the answers to the computational questions you should include your workings. Partial credit
cannot be awarded if the final numbers presented are wrong through errors of omission, calculation
etc. unless your workings are shown.

In the essay-type questions, you should structure your answers, starting with an introductory
paragraph that outlines the answer you will be giving and the arguments you will be making. In the
main body of your answer, describe the theories and concepts that provide the basis of the argument
that can then be developed and substantiated. The concluding section should draw together the
main points of your argument in a summary.

Read widely

You are expected to read beyond the subject guide and the additional material, and any insights you
gain should be included in your answers. For example, you could go beyond the textbook and
subject guide material on the efficient markets hypothesis and read a wide range of articles on
various research studies on semi-strong and weak form markets. You will then have the material you
need to answer a question on efficient markets.

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 Examiners’ commentaries 2022

Key steps to improvement

Read beyond the subject guide.
Practise computational questions in the subject guide, textbooks and any other appropriate
sources.
Practise both computational and written questions from past examination papers. As the
examination draws closer, practise under time pressure, remembering that you probably
only have approximately 36 minutes per question in which to write your answer.
Ensure your written answers to your practice questions do attempt to answer the questions
posed and not the one you wish you could be answering. Learn to focus on the contents,
context and requirements of that specific question.

Readings for this paper

Please note that shorthand will be used when referring to the following textbooks:

BMA – Brealey, R.A., S.C. Myers and F. Allen, Principles of corporate finance. (New York:
McGraw–Hill Inc, 2010) tenth edition [ISBN 9780071314268].
SG – subject guide. Fung, L. Financial management. (London: University of London
International Programmes, 2015).

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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AC3059 Financial management

Examiners’ commentaries 2022

AC3059 Financial management

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions

Candidates should answer FIVE of the following EIGHT questions: FOUR from Section A and
ONE from Section B. All questions carry equal marks.

Workings MUST BE submitted for all questions requiring calculations. Any necessary assumptions
introduced in answering a question are to be stated.

Section A

Answer four questions from this section.

Question 1

Cherubin Inc. is currently expected to pay a dividend of $1m in exactly one year
time, after which the dividend is expected to grow at 5% per annum forever. The
company’s CEO has however heard that the value of a share depends on the flow of
dividends and therefore is about to announce that year 1’s dividend will be increased
to $2m and that the extra cash required for the additional dividend will be financed
through a contemporaneous issue of equity. In subsequent years, the dividend will
remain as previously forecasted. The firm has 2m shares outstanding. The market
value of these shares is $20m prior to the announcement of the new dividend policy.

Required:

(a) Assume that the newly issued shares are issued at the cum-dividend price at the
end of the year. What is the issue price and how many shares will the firm need
to issue?
(4 marks)

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 Examiners’ commentaries 2022

(b) What is the payoff to the existing shareholders as of the current date
immediately after the firm announces the additional dividend?
(4 marks)
(c) Assume now instead that the newly issued shares are issued at the ex-dividend
price at the end of the year. What is the issue price and how many shares will
the firm need to issue? What is the payoff to the existing shareholders as of the
current date immediately after the firm announces the additional dividend?
(8 marks)
(d) Is the payoff to the existing shareholders as of the current date different in
parts (b) and (c)? Explain why or why not.
(4 marks)

(Total: 20 marks)

Reading for this question

BMA Chapters 4, 15 and 16.

SG Chapters 9, 13 and 15.

Approaching the question

This question addresses issues related to dividend policy and valuation. This topic is a key one in
the syllabus of the Financial Markets unit. Many candidates, however, did not perform well
when attempting to solve this question. One of the main reasons for this was because of a lack of
knowledge of the difference between a cum-dividend and an ex-dividend share price (or equity
value).

In order to answer this question, one relies on the fact that the intrinsic value of a stock can be
calculated as the present value of all future expected dividends, the latter expression collapsing
to the Gordon growth valuation model when dividends are expected to grow at a constant rate.
Assuming that capital markets are efficient, one can derive the cost of equity capital by using the
valuation formula and the firm’s market value of equity. The proportion of equity which has to
be offered to shareholders in exchange for funding the extra dividend is given by the proportion
of post-issue equity value accounted for by the extra dividend.

Suggested solution:

Let us denote the current market value of equity by V0 (V0 = $20m), the expected dividend next
year by DIV 1 (DIV 1 = $1m), the expected growth rate by g (g = 5%), the extra dividend to be
paid at the end of year 1 by EDIV 1 (EDIV 1 = $1m), and the current number of shares by N
(N = 2m).

(a) In order to solve this question, we need the cost of equity capital which can be derived from
Gorton growth valuation formula assuming that capital markets are efficient:
DIV 1
V0 =
rE − g
and equivalently:
DIV 1 $1m
rE = +g = + 5% = 10%.
V0 $20m
Let us denote the cum-dividend value of equity at the end of the year by V1Cum . It follows
that:
V1Cum = V0 (1 + rE ) + EDIV 1 = $20m × 1.1 + $1m = $23m.
The proportion of equity to be provided to new shareholders in exchange for funding the
extra dividend, %New, is thus given by:
EDIV 1 $1m
%New = = = 4.35%.
V1Cum $23m

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AC3059 Financial management

If n denotes the number of shares provided to the new shareholders, then:

n
%New = .
n+N
Equivalently:
N
n = %New × = 0.091m.
1 − %New
The issue price is thus:
V1Cum
P1 = = $11.
N +n

(b) The payoff to existing shareholders as of the current date immediately after the firm
announces the additional dividend is:
V1Cum
(1 − %New) × = $20m.
1 + rE

(c) Let us denote the cum-dividend value of equity at the end of the year by V1Ex . It follows
that:
DIV 1 × (1 + g) 1 + 5%
V1Ex = = $1m × = $21m.
rE − g 10% − 5%
The proportion of equity to be provided to new shareholders in exchange for funding the
extra dividend, %New, is thus given by:

EDIV 1 $1m
%New = = = 4.76%.
V1Ex $21m

The number of shares n provided to the new shareholders is thus:

N
n = %New × = 0.1m.
1 − %New
The issue price is thus:
V1Ex
P1 = = $10.
N +n
The payoff to existing shareholders as of the current date immediately after the firm
announces the additional dividend is:
DIV 1 + EDIV 1 + (1 − %New) × V1Ex
= $20m.
1 + rE

(d) This question takes place within the Miller–Modigliani framework. It is therefore not
surprising to find out that the payoff to existing shareholders is independent of both
dividend policy and the way dividends are funded.

Question 2

You are the owner of Fidelio plc, a company with £100m of debt maturing at the
end of the year. Fidelio generates at the end of the year a cash flow equal to either
£120m or £60m with equal probability. There are no subsequent cash flows.
Assume risk neutrality and no time value of money.

Required:

(a) What are the current market values of debt and equity?
(3 marks)

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 Examiners’ commentaries 2022

(b) Now assume that you have an opportunity to invest another £20m that yields
with certainty another £25m at the end of the year. What are the market
values of debt and equity after the investment? As the owner of Fidelio plc,
would you take this investment opportunity if you had to fund the investment
out of pocket? Explain.
(7 marks)
(c) If you were instead to issue equity to finance this investment opportunity, what
fraction of equity would you have to offer to the new investors? Would you issue
equity and invest in the new investment opportunity? Explain.
(6 marks)
(d) If you were to issue debt that is more senior than the current debt to finance
this investment opportunity, what would the face value of the new debt be?
Would you issue the new debt and invest in the new investment opportunity?
Explain.
(4 marks)

(Total: 20 marks)

Reading for this question

BMA Chapters 15 and 18.

SG Chapter 12.

Approaching the question

This question addresses issues related to capital structure. It illustrates how managers of firms
with high levels of debt may not invest in positive NPV projects if they maximise the interests of
existing shareholders when existing shareholders have to fund the investments through equity
injections because the projects are not risky enough (debt overhang problem). In order to find
out whether such a manager would invest in a project, one needs to derive the NPV of the
project’s incremental cash-flows to the existing equity holders, keeping in mind that equity
holders only get any benefit in any state of nature once debt holders are paid what was promised
to them (the face of debt in this question).

Suggested solution:

(a) Let us first derive the cash-flows to equity holders and debt holders generated at the end of
the year, taking into account that the promised repayment to debt holders is $100m:

State of Nature
Low High
(50%) (50%)
CF ($m)
CF to Debt Holders 60 100
CF to Equity Holders 0 20
CF to All Claim Holders 60 120

If VD and VE , respectively, denote the value of debt and the value of equity, it follows that:

1
VD = × ($60m + $100m) = $80m
2
and:
1
VE = × ($0m + $20m) = $10m.
2

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AC3059 Financial management

(b) Let us again derive the cash-flows to equity holders and debt holders generated at the end of
the year when the project is invested in before deriving the incremental cash-flows to equity
holders generated by the project at the end of the year:

State of Nature
Low High
(50%) (50%)
CF ($m)
CF from Assets in Place 60 120
CF from Project 25 25
CF to All Claim Holders 85 145
CF to Debt Holders 85 100
CF to Equity Holders 0 45
Incremental CF to Equity Holders (Project) 0 25

Hence:
1
NPV E (Project) = −I + PV (Incremental CF) = −$20m + × $25m = −$7.5m.
2
As the owner of this company, you would thus not take this investment opportunity if you
had to fund the investment out of pocket as the NPV of this project would be negative to
you.

(c) Post issue, the value of equity is:

1
VE = × ($0m + $45m) = $22.5m.
2
In efficient capital markets, new investors would have to be offered a proportion of equity:

$20m
α= = 8.9%.
$22.5m
Your ex-ante worth is thus:
(1 − α) × $22.5m = $2.5m
which is strictly lower than $10m, which is the value of your equity when not investing.
You would therefore not take this investment opportunity by issuing equity to new investors.

(d) Let us again derive the cash-flows to equity holders and debt holders generated at the end of
the year when the project is invested in before deriving the incremental cash-flows to equity
holders generated by the project at the end of the year:

State of Nature
Low High
(50%) (50%)
CF ($m)
CF from Assets in Place 60 120
CF from Project 25 25
CF to All Claim Holders 85 145
CF to Senior Debt Holders 20 20
CF to Junior Debt Holders 65 100
CF to Equity Holders 0 25
Incremental CF to Equity Holders (Project) 0 25

The value of your equity when investing in the project by financing it with an issue of senior
debt, (1/2)($0m + $25m) = $12.5m, is strictly higher than the value of your equity when not
investing ($10m). You would thus issue senior debt and invest in the project.

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 Examiners’ commentaries 2022

Question 3

Tosca Inc. is currently trading at $100 per share. After examining the stock of
Tosca, you have determined that in one year time its price will either increase to
$130 with probability 55% or decrease to $90 with probability 45%. Tosca does not
pay any dividend. A European call option on Tosca with an exercise price of $100 is
currently trading at $8.82.

Required:

(a) What are the implied risk-neutral probabilities and the implied one-year
risk-free rate in the economy? If unable to solve the relevant equations, check
that the implied risk-neutral probability of seeing an increase in the stock price
is 30% and the risk-free rate is 2% per annum.
(8 marks)
(b) Determine the replicating portfolio of the call option.
(8 marks)
(c) What is the arbitrage free price of a European put option with an exercise price
of $95?
(4 marks)

(Total: 20 marks)

Reading for this question

BMA Chapters 20 and 21.

SG Chapter 19.

Approaching the question

This question addresses issues related to the pricing of European call and put options. Parts of
the question rely on the use of the risk-neutral pricing method in a binomial setting. According
to this method, the price of any asset can be derived as the present value of the asset’s payoffs
obtained at the end of the period using risk-neutral probabilities and discounted at the risk-free
rate. Both the risk-neutral probabilities and the risk-free rate can be derived from the application
of the risk-neutral pricing method to Tosca’s call option and underlying share using the share
and option prices provided in the question. Whilst few candidates elected to solve the two linear
equations with two unknowns, most of the marks were granted for checking that the risk-neutral
probabilities and the risk-free rate provided in the question satisfied the required conditions.

Suggested solution:

(a) Let us, respectively, denote by S, Su , Sd , q, r, C and X the current share price, share prices
in one year in the upper node and lower node, risk-neutral probability of the share price
ending up in one year in the upper node, the risk-free rate, the price of a call option on the
share with a maturity of one year, and the exercise price of this option.
The current share price must be equal to the present value of the share price obtained at the
end of the year as valued by a risk-free investor. It hence follows that:

qSu + (1 − q)Sd
S= .
1+r
Equivalently:
qSu + (1 − q)Sd = S(1 + r).
Similarly, the current price of the call option must be equal to the present value of the call
option’s payoffs obtained at the end of the year as valued by a risk-free investor. If Cu and

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AC3059 Financial management

Cd , respectively, denote the payoffs to this option in one year’s time, then:

Cu = max(0, Su − X) = $130 − $100 = $30

and:
Cd = max(0, Sd − X) = $0.
It then follows that:
qCu + (1 − q)Cd
C=
1+r
or equivalently:
qCu
= 1 + r.
C
It follows that:
Sd
q= = 30%
(S × Cu /C) − Su + Sd
and:
qCu
r= − 1 = 2%.
C
(b) Consider a portfolio consisting of a shares of Tosca and b units of the risk-free asset
replicating the payoffs of the call option at maturity of the option. Hence:

aSu + b(1 + r) = Cu and aSd + b(1 + r) = Cd .

It follows that:
Cu − Cd $30
a= = = 0.75
Su − Sd $130 − $90
and:
Cd − aSd −0.75 × 90
b= = = −66.18.
1+r 1.02
Using a no-arbitrage argument:

C = aS − b = 0.75 × $100 − $66.18 = $8.82.

(c) Let us, respectively, denote by P , Pu and Pd the current price of the put option and payoffs
to this option in one year’s time in the upper and lower nodes. Hence:

Pu = max(0, X − Su ) = $0

and:
Pd = max(0, X − Sd ) = $95 − $90 = $5.
The current price of the put option must be equal to the present value of the put option’s
payoffs obtained at the end of the year as valued by a risk-free investor.
It then follows that:
qPu + (1 − q)Pd (1 − q)Pd
P = = = $3.43.
1+r 1+r

Question 4

The risk-free rate is 2% per annum. The market portfolio has an annual mean
return of 14% and annual return standard deviation of 26%.

Required:

(a) An investor wishes to invest in a stock as she likes its high expected return of
18% per annum. This stock has an annual return standard deviation of 40%.
Construct for this investor a portfolio with the same expected return but lower
risk, telling her what weights to employ and the level of risk she would face.
(5 marks)

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 Examiners’ commentaries 2022

(b) A more cautious investor wishes to invest in another stock as he likes the low
annual return standard deviation of 20%. This stock has an expected return of
7%. Construct for this investor a portfolio with the same return standard
deviation but higher expected return, telling him what weights to employ and
the return that he would expect.
(5 marks)
(c) Write down and interpret the CAPM equation that holds in this setting.
(4 marks)
(d) Briefly explain how one would empirically test the validity of the CAPM model.
Comment on the limitations of your empirical test.
(6 marks)

(Total: 20 marks)

Reading for this question

BMA Chapters 4, 8 and 13.

SG Chapters 5, 6 and 7.

Approaching the question

This question addresses issues related to portfolio design (relying on mean–variance analysis) and
asset pricing. Answering the first half of the question relies on the fact that investors can invest
part of their funds in the market portfolio of risky assets and the remaining part in the risk-free
asset in order to obtain the desired level of risk or expected return and be better off than they
would have been by investing in any stock. Determining the proportions to invest in either asset
requires knowledge of how to calculate the expected return and variance of a portfolio given the
information provided on the assets this portfolio is invested in. Answering the second half of the
question relies on knowledge of the CAPM and ways to test its validity.

Suggested solution:

(a) Let us, respectively, denote the stock the investor wishes to invest in by A, the market
portfolio of all risky assets by M , and the risk-free rate by rF . Consider CAL A, the capital
allocation line going through A. Its slope is the Sharpe ratio of A:
E(rA ) − rF 18% − 2%
SA = = = 40%.
σA 40%
This Sharpe ratio is lower than the Sharpe ratio of the market portfolio, which is the slope
of the capital market line (CML):
E(rM ) − rF 14% − 2%
SM = = = 46.2%.
σM 26%
By appropriately investing in the market portfolio and borrowing at the risk-free rate, one is
thus able to construct a portfolio P with an expected return equal to E(rA ) = 18% with a
lower standard deviation of returns than σA = 40%.
More specifically, let us invest proportion of funds %M in the market portfolio such that:

E(rP ) = %M E(rM ) + (1 − %M )rF = E(rA ).

Equivalently:
E(rA ) − rF 18% − 2%
%M = = = 133.3%.
E(rM ) − rF 14% − 2%
Furthermore, as portfolio P lies on the CML, SP = SM , and hence:
E(rP ) − rF E(rM ) − rF
SP = = .
σP σM

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AC3059 Financial management

Equivalently:
E(rP ) − rF
σP = σM = 34.7% < σA = 40%.
E(rM ) − rF

(b) Let us denote the stock the investor wishes to invest in by B. Consider CAL B, the capital
allocation line going through B. Its slope is the Sharpe ratio of B:

E(rB ) − rF 7% − 2%
SB = = = 25%.
σB 20%

This Sharpe ratio is lower than the Sharpe ratio of the market portfolio, which is equal to
46.2% (as calculated in the previous subquestion).
By appropriately investing in the market portfolio and lending at the risk-free rate, one is
thus able to construct a portfolio Q with a standard deviation of returns equal to σQ = 20%
with an expected return satisfying the following equality:

E(rQ ) − rF E(rM ) − rF
SQ = = .
σQ σM

Hence:
(E(rM ) − rF )σQ (14% − 2%)20%
E(rQ ) = rF + = 2% + = 11.2% > E(rB ) = 7%.
σM 26%

More specifically, let us invest proportion of funds %M in the market portfolio such that:

E(rQ ) = %M E(rM ) + (1 − %M )rF .

Equivalently:
E(rQ ) − rF 11.2% − 2%
%M = = = 76.9%.
E(rM ) − rF 14% − 2%

(c) The CAPM equation states that any portfolio lies on the CAPM line with equation:

E(r) = rF + β(E(rM ) − r).

Standard deviation as a measure of risk is irrelevant (as investors are fully diversified). Only
systematic risk matters.

(d) Candidates were expected to introduce tests of association between systematic risk and
average returns, explaining the rationale for them and their limitations. Candidates were
then expected to discuss empirical evidence as explained in the subject guide and core
textbook.

Question 5

Byder plc is considering a possible acquisition of Targetty plc. You have been asked
to evaluate the merits of the proposed merger. Here are the data on the two
companies before the acquisition:

Targetty Byder
Number of shares outstanding 1,000m 5,000m
Price-to-Earnings Ratio 10 2
Expected Earnings per Share (£) 0.5 3

Byder has valued the synergies from the merger as being £2,500m.

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 Examiners’ commentaries 2022

Required:

(a) If Byder wishes to finance the acquisition with shares in the merged company,
what is the maximum number of shares it would be willing to offer to Targetty’s
shareholders? Explain.
(6 marks)
(b) What would be the consequences of such a bid on expected earnings per share
of Byder if we assume that the synergies will lead to an increase in expected
earnings of £200m in the first year? Does the effect on earnings per share of the
merged company affect the merits of the transaction?
(6 marks)
(c) Instead of the share exchange, Byder has enough surplus cash to finance the
acquisition with a cash offer. Alternatively, Byder could return the cash to its
shareholders before making the bid and continue with the share offer. How
would you advise between the share offer and returning the cash to shareholders
versus using the cash to make the acquisition?
(5 marks)
(d) Can takeover defences ever be justified? Explain.
(3 marks)

(Total: 20 marks)

Reading for this question

BMA Chapters 15 and 31.

SG Chapters 9 and 16.

Approaching the question

This question addresses issues related to mergers and acquisitions and valuation.

The first part of the question investigates the highest reasonable bid for a target company which
can be made by a bidding company. Assuming that the bidding company’s managers maximise
the interests of its shareholders, it is the bid that makes the acquisition a zero NPV transaction
for the shareholders of the bidding company, that is, the intrinsic value of the target company on
a stand-alone basis plus the present value of the synergies from the acquisition (value of the
target company to the acquiring company). When the acquisition is paid for using shares in the
combined company, the proportion of equity which has to be offered to shareholders of the target
company is given by the proportion of the combined firm’s equity value accounted for by the bid
for the target company.

The second part of the question investigates the effect of the bid made for the target company on
expected earnings per share for the combined company and whether it affects the merits of the
transaction. Answering this part of the question involves aggregating the expected earnings per
share constituents of the combined company and dividing the aggregate by the number of shares
in the combined company post acquisition. The effect of the bid on expected earnings per share
of the combined company on the merit of the transaction is, however, irrelevant as the
acquisition is a zero NPV investment for the shareholders of the bidding company.

Suggested solution:

(a) Let us refer to Targetty as a stand-alone company as T , Byder as B, and the combined firm
as TB. Let us furthermore assume that capital markets are efficient in the sense that market
values are equal to intrinsic values, and that the capital market does not know that an
acquisition is imminent.

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The value of the combined firm is thus:

VT B = VT + VB + PV (Synergies)

with:

VT = NT × EPS T × PE T = 1,000m × £0.5 × 10 = £5,000m

VB = NB × EPS B × PE B = 5,000m × £3 × 2 = £30,000m.

It hence follows that:

VT B = £5,000m + £30,000m + £2,500m = £37,500m.

The bid offer making the acquisition a zero NPV transaction is:

VT + PV (Synergies) = £5,000 + £2,500m = £7,500m.

The proportion of shares in the combined company offered to T ’s shareholders that is

consistent with this bid is thus:
VT + PV (Synergies) £7,500
%T = = = 20%.
VT B £37,500

If N and n, respectively, denote the current number of shares in B and the number of shares
provided to T ’s shareholders, then:
n
%T = .
n+N

Equivalently:
N
n = %T × = 1,250.
1 − %T

(b) Let us first derive the expected earnings from the combined firm:

EarningsT B = EarningsT + EarningsB + EarningsSynergies

= NT × EPS T + NB × EPS B + EarningsSynergies

= (1,000m × £0.5) + (5,000m × £3) + £200m

= £15,700m.

It then follows that:

EarningsT B £15,700
EPS T B = = = £2.51 < EPS B = £3.
n+N 5,000 + 1,250

The effect on earnings per share of the merged company does not affect the merits of the
transaction as the acquisition is still a zero NPV investment for the shareholders of Byder.

(c) Candidates were expected to introduce considerations such as risk sharing offered by share
offers, share offers likely to be more costly as managers of acquiring companies being more
likely to make them when they know that their shares are overvalued, taxation issues, ease
with which acquiring companies can raise cash etc.

(d) Candidates were expected to write about takeover defences undermining the role of the
market for corporate control and the need for undervaluation issues in capital markets to
justify takeover defences.

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 Examiners’ commentaries 2022

Question 6

MA Hectorer plc is a specialist retailer of products for mothers to be, babies and
children up to the age of eight. It offers products ranging from clothing, furniture
for children, bedding, and toys.

One very important change in the retail industry in general, and clothing industry
in particular has been the increasing using of online services for purchases. Fewer
people walk into the stores, and those that do walk-in tend to try something in the
store but prefer to purchase similar items online. Customers also expect stores to
provide a good ‘experience’ rather than just have essentials. Another trend change
in this industry has been that consumers have become more discerning. Customers
are asking for wider variety of products and better fashion choices. In order to
overcome some of the issues the company faced, the company appointed a new CEO
at the end of 2018.

You have information about key performance indicators over the last several years,
key ratios and some information about the performance of its competitors:

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AC3059 Financial management

For information, MA Hectorer’s main competitors had returns on common equity

above 20% in 2014 declining linearly to 5% in 2021 and operating margins of 9% in
2014 declining linearly to 7% in 2021.

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 Examiners’ commentaries 2022

Required:

(a) Derive the following ratios for MA Hectorer from 2019 to 2021:
i. Operating margins
ii. Return on sales
iii. Asset turnover
iv. Financial leverage (Total Assets/Equity)
v. Return on Equity.
(10 marks)
(b) How has MA Hectorer been performing over the years?
(5 marks)
(c) Identify factors which caused the change in performance.
(3 marks)
(d) How did MA Hectorer fund any changes that had to be implemented?
(2 marks)

(Total: 20 marks)

Reading for this question

BMA Chapter 28.

SG Chapter 17.

Approaching the question

This question provides candidates with an opportunity to analyse a company using financial
ratios. In the first part of the question, candidates have to compute a number of performance
and leverage ratios over time (the firm’s return on equity, its decomposition, as well as its
operating margin). Marks were awarded for any reasonable ratio being calculated. In the second
part of the question, candidates are asked to comment on the evolution of the company’s
performance over time, being provided with comparable information on the company’s main
competitors. A close look at the tables provided in this question is enough to answer each
sub-question. Only two or three points were expected to be made by sub-question as long as they
were backed up by evidence from the tables.

Suggested solution:

(a) The following ratios for MA Hectorer from 2019 to 2021 can be found in the following table:

2018 2019 2020 2021

Revenue (Rev) 724.9 714 682 667
Operating Profit (OP) −19.1 −7 13 10
Net Profit (NP) −27.5 −15.1 6.4 8.2
Total Assets (TA) 300.2 331.1 347.4 347.8
Equity (E) 15.2 77.7 89.1 81.4

Operating Margin (OM) OP/Rev −2.63% −0.98% 1.91% 1.50%

Return on Sales (ROS) NP/Rev −3.79% −2.11% 0.94% 1.23%
Asset Turnover (AT) Rev/TA 241.47% 215.6% 196.3% 191.8%
Financial Leverage (FL) TA/E 1,975.00% 426.1% 389.9% 427.3%
Return on Equity (ROE) NP/E −180.92% −19.43% 7.18% 10.07%

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AC3059 Financial management

(b) The company performed poorly in 2011/12. All profitability ratios were very low or
negative. It was not an industry-wide problem. The company then slowly worked towards
improving its performance. It turned profitable in 2016. The company continued giving
dividends in 2011 and 2012 despite having very small profit or even losses. Dividends were
finally stopped in 2013.

(c) The company refinanced – took bank loans to support future growth. It issued stock in
2015, suggesting belief that there were growth prospects. It closed down stores, increased
online presence and reduced discounts.

(d) The company financed changes through issues of debt and equity.

Section B

Answer one question from this section.

Question 7

As of February 2nd, 2022, Tesla’s market capitalisation was higher than the
combined capitalisation of the next 15 largest car manufacturers. Discuss whether
or not this is consistent with efficient markets.

(Total: 20 marks)

Reading for this question

BMA Chapters 15 and 31.

SG Chapters 8 and 15.

Approaching the question

Candidates were invited to introduce a valuation method and discuss the drivers of valuation (for
example, growth and expected profitability), think about the automotive industry, the
comparative advantage Tesla may have in terms of battery technology, possible bubbles in the
tech industry etc. Many candidates instead made no effort to answer the question and discussed
instead the three forms of market efficiency (weak, semi-strong, and strong). The latter type of
answer was not rewarded generously.

Question 8

Advise on suitable capital structures and dividend policies for tech start-up firms.

(Total: 20 marks)

Reading for this question

BMA Chapters 16 and 18.

SG Chapters 11, 12 and 13.

Approaching the question

Candidates were invited to discuss the characteristics of tech start-up firms and their
implications for capital structure and dividend policies. These firms tend to be risky and

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 Examiners’ commentaries 2022

unprofitable, making it difficult to borrow funds in the first place and not generating substantial
expected tax shields. These firms may also be difficult to value which implies that they may be
undervalued when attempting to issue equity. They may also have high cash burn. One would
thus expect these firms to have low leverage and not to have high dividend payout ratios in order
to retain cash that may be required in the future to fund investments.

It was important for candidates to tailor their advice taking into account the characteristics of
tech start-up firms. Writing everything one knew on capital structure and dividend policy was
not rewarded generously.

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