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The january 2013 exam questions and solutions for the ag210 business finance course at the department of accounting and finance. The exam covers topics such as discounted cash flow calculations, inventory management, earnings per share, and capital structure. Students are required to answer one question from each of the three sections: a, b, and c.
Typology: Exercises
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Calculators must not be used to store text and/or formulae nor be capable of communication. Invigilators may require calculators to be reset
8 Patrick McColgan
c. Show how your discounted cash flow calculations could be amended to incorporate future net cash flows for the next forty years on the project. You should ignore any implications related to the resale of the firm’s machinery and the tax depreciation of the machinery. (7 1/3 marks)
Sensible adjustment would be to strip out tax depreciation, working capital, and resale value of machine from final year net cash flows. Final year net cash flows would be £7,500,000 minus £3,600,000 variable costs, £600,000 fixed costs, to give taxable profit of £3,300,000. Taxes would be 22% of this paid one year in arrears of £726,000. Net cash flows would be a forty year annuity of £3,300,000 beginning in year 6 minus a 40 year annuity of £726,000 in tax beginning in year 7. Working capital of £800,000 would be recovered in year 46. The firm would also have to add £800,000 back at time 5.
(Total 33 1/3 marks)
8 Patrick McColgan
Question 2 Mears Wholesalers is a distributor of chocolates and it supplies 400 retail stores from a warehouse in Coventry, England.
Mears sells approximately 50,000 cases a week, with little variation over time. The average cost per case is £15. The average annual holding cost is about 10 per cent of the value of items being held, i.e. one case would cost about £1.50 to store for a year. The finance director is considering the company’s inventory policy, and has started his investigation of the optimal inventory policy.
At present Mears Wholesalers places an order every two weeks (an order of 100,000 cases) and this implies holding on average 50,000 cases in stock. The ordering cost is estimated on the basis of processing this order (sending the order, making payment, delivery charges, etc.) and it is found that this cost varies very little with the size of the order. The cost of a typical order is put at £500.
a. Calculate the annual order cost and holding cost of the firm’s existing inventory policy. (4 marks)
Annual holding cost = ½ x Q x CH = 0.5 x 100,000 x £1.50 = £75,
Annual ordering cost = (D/Q) x CO = (52 x 50,000 / 100,000) x £500 = £13,
b. Explain how the firm should amend its inventory management policy in light of your answer to part a). (4 marks)
The firm’s holding costs are much higher than the annual order costs. This suggests that Mears Wholesalers is holding too much inventory and should reduce this balance by cutting back on stock and ordering more frequently.
c. Calculate the economic order quantity for Mears Wholesalers, the annual order and holding costs under this strategy, and the order frequency implied by this strategy. (8 marks)
Q = (2 x D x CO / C (^) H ) 0.5^ = (2 x 52 x 50,000 x £500 / £1.50)0.5^ = 41,633.32 cases
Answer ONE question
Question 3 Shandy plc is expected to generate earnings before interest and tax of £90 million next year. It is an all equity financed company that is run efficiently. Following discussions with the company's merchant bank a proposal for financial restructuring is under consideration. It has been suggested that the company raise £100 million through an issue of debentures at 9 per cent and to use the proceeds to buy back shares. With a corporate tax rate of 30 per cent the cost of debt is believed to be well below that of equity. The company has 400 million shares outstanding and the share price is currently £1.00.
a. Determine the expected EPS for the company before and after the proposed restructuring, and level of earnings before interest and tax at which the EPS would be the same for the alternative capital structures. (12 marks)
Interest 0 9 PBT 90 81 Tax 27 24. PAT 63 56. No of shares 400m 300m EPS £0.1575 £0.
EBIT^ (1 – Tc )/(N(U) = (EBIT^ - Int) (1 – T (^) c)/N(G) EBIT/400 = (EBIT^ - 9)/ 300 EBIT^ = 400 EBIT^ - 3600 EBIT^ = 3600 / 100 EBIT^ = 36m
EPS = £36m * (1 – 0.30) / 400million = £0. EPS = (£36m - £9m) * (1 – 0.30) / 300million = £0.
After further deliberation, the firm believes it has identified a profitable investment project that will require £50million to invest in. The company decides to raise equity through a rights offering to fund the expansion project. The shares will be sold at a 20% discount to the current market price of £1.00 per share.
b. Devise the terms of the rights offer and calculate the theoretical ex-rights price and the value of a right to purchase one new share. (8 marks)
PS = £1.00 x (1 – 0.20) = £0. N* = £50m / £0.80 = 62.5million shares N* / N = 62.5 / 400 = 5 for 32 Px = (£400m + £50m) / 462.5 = £0. Px – P (^) s = £0.9730 - £0.80 = £0.
c. Show that in theory an investor holding 160 shares will be equally well off irrespective of whether they take up their rights, sell the rights, or tail swallow (sell off rights to fund the purchase of the maximum number of additional share with no new investment).
Take up rights: Investor owns 160 shares @ P 0 = £ Purchase 25 shares @ P (^) S = £ Cost of portfolio = £ Value of portfolio, owns 185 shares @ Px = £
Sell rights: Investor owns 160 shares @ P 0 = £
Sells rights to purchase 25 shares @ Px – Ps = -£4. Cost of portfolio = £155. Value of portfolio, owns 160 shares @ Px = £155.
8 Patrick McColgan
Question 4
You have been asked to evaluate the acquisition of Miner Plc by Trader Plc. The two firms operate in the mining industry. Miner Plc mainly focuses on extracting coal and precious metals while Trader Plc has a small amount of similar mining operations but derives most of its revenue and profit from trading of these metals.
Trader Plc is planning to apply its own weighted average cost of capital to the acquired business and has provided you with the following information on its historical share price performance:
Year FTSE-All Share Trader Plc 2003 -2% 12% 2004 6% 15% 2005 18% 20% 2006 15% 25% 2007 5% -10% 2008 -30% -50% 2009 +25% +70% 2010 +10% +25% 2011 +2% -10% 2012 +15% +25%
The arithmetic average historical risk premium over 1926-2012 was 7.0%, while the geometric average was 5.5%. The annualised yield on 3- month t-bills is 1%, while the annualised yield on 20-year government bonds is 5%. You are also provided with information on the equity beta of Trader Plc historically:
Company Equity Beta 2009 2. 2010 1.
8 Patrick McColgan
Forecast 2013 1.
The current share price of Trader Plc is 400pence per share. Next year’s dividend is forecast at 40pence per share, which represents half of its forecast earnings per share of 80pence. Dividends are expected to grow at a constant rate of 8% per year. Trader Plc has 3,000million shares outstanding at present.
The acquisition will be financed by a combination of debt and equity in order to maintain the existing capital structure of the business. Prior to the acquisition, Trader Plc has bank borrowings with a value of £6,000million outstanding. The company pays interest based on LIBOR + 3%. Annualised 3-month LIBOR is currently 2.50%. The company expects to pay tax on the net cash flows of the acquired company at a marginal rate of 25%.
As the finance director of the company you have been asked to provide information on the following to the company’s board of directors:
a. A recommendation as to the appropriate cost of equity capital for the company. Your discussion should cover a range of methods based on the data provided above, and should highlight the relative strengths and weaknesses of the approaches considered. You should conclude with a recommendation as to the most appropriate cost of equity capital for the company and justify your choice. (28 1/3 marks)
Trader Plc arithmetic mean 2002-2011: 12.20% Trader Plc geometric mean 2002-2011: 7.59%
Approach relies on past performance being repeated in the future, which is unlikely is markets are efficient and the companies have changed over time. More importantly in this scenario, both are clearly inappropriate given the poor performance of the company in 2007 and 2008 during the credit crunch.
Earnings valuation method: r = EPS1 / P0 = 80 / 400 = 20.00%
Assumes the company has no growth prospects, which seems inappropriate given the acquisition.
r (^) WACC = (6,000 / 6,000 + 12,000) * 4.125% + (12,000 / 6,000 + 12,000) * 14.35% r (^) WACC = 10.94%
(Total 33 1/3 marks)
Answer ONE question
Question 5 Miller and Modigliani argue that a firm’s payout policy is irrelevant to the valuation of a firm. Critically evaluate this argument in light of share valuation models that estimate the value of a firm’s stock as the present value of future dividend payments. (33 1/3 marks)
MM argue that ‘packaging’ of cash flows does not impact the value of the firm, but that the investments of the business generating these cash flows are what matters. This does not contradict the Gordon growth model because under MM low or zero dividends today reflect that the company may be investing in positive NPV projects that will generate higher cash flows in the future, increasing the ability to pay higher dividends at this time.
Question 6 Distinguish between operating and financing leases and outline the main types of assets that are likely to be acquired through each type of lease. Critically evaluate the main reasons put forward for leasing and whether these primarily relate to operating or financing leases. (33 1/3 marks)
Operating leases typically for shorter than useful life of the asset, the lessor is expected to maintain the asset, and the lessee has the option to cancel the contract. Financing leases are generally for the economic life of the asset, the lessee is expected to maintain the asset, the lease generally cannot be cancelled
[END OF PAPER]
8 Patrick McColgan
Table A-1 Future Value of £1 at the end of n periods = (1+r)n
Table A-2 Present Value of £1 to be received after n periods = 1/(1+r)n
Table A-4 Present Value on an Annuity of £1 per period for n periods = [1 – 1/(1 + r)n]/r
