1. Time Value of money – investment criteria
a) You are planning to retire in 25 years time. Immediately after your retirement, you wish to go for a round the world trip lasting one year. Your monthly expenses for the trip work out to be £9000 and the first withdrawal will be made at the end of the month after your retirement. You also want to provide yourself with £35,000 a year for next 15 years on your return from the world trip. How much you should save every month to provide for the above if the effective rate of interest is 14% per annum.
b) Your firm has a retirement plan that matches all employee contributions with employer contributions on a two-to-one basis. That is if an employee contributes £1,000 per year, the company will add £2,000 to make the total contribution £3,000. The firm guarantees a fixed 6 per cent return on the funds. Alternatively, you can provide for retirement yourself, and you think you can earn 9 per cent on your money. The first contribution will be made one year from today. At that time and every year thereafter, you will put £2,500 into the retirement account, the same amount as you would have contributed to the company pension fund. You plan to retire in 30 years. Are you going to be better off participating in the company scheme or making your own arrangements? Explain the basis of your answer (ignore any tax considerations).
The manager responsible for the pension fund of Ruthin plc has to present a report to the Board of Directors on the financial position of the fund. He decides to use the position of the typical employee to illustrate the fund’s position. There is £30,000 currently held in the fund for each employee. The typical employee has 15 years to go to retirement and the company’s actuary has proposed that the company should anticipate having to fund pension payments over a retirement period of 12 years for the average employee. The average pension payment per annum is expected to be £12,000 and the rate of return expected on the pension funds investment is expected to be 6 per cent. The manager needs to determine the constant annual sum that the company needs to put into the pension fund for each of the next 15 years to be able to meet the fund’s obligations. Determine this annual sum. (Assume all payments into the fund and all pension payments are made at the end of each year.)
d) Explain what is meant by the internal rate of return of an investment and discuss its relationship to the NPV of an investment.
e) Explain the problems posed for the use of the IRR when it is necessary (i) to choose between two investments and when (ii) investments are characterised by negative net cash flows at the end of their lives.
f) Discuss and evaluate the use of the payback period as an investment criterion.
(TOTAL 20 MARKS)
2.Capital Expenditure Decisions and Investment Criteria
Raindeer PLC is a highly profitable electronics company that manufactures a range of innovative products for industrial use. Its success is based to a large extent on the ability of the company’s development group to generate new ideas that result in commercially viable products. The latest of these products is just about to undergo some final tests and a decision has to be taken whether or not to proceed with an investment in the facilities required for manufacturing. You have been asked to undertake an evaluation of this investment.
The company has already spent £750,000 on the development of this product. The final testing of the product will cost about £40,000. The head of the development group is very confident that the tests will be successful based on the work already undertaken. Another company has already offered Raindeer £1.10 million for the product’s patent and an exclusive right to its manufacture and sale, even though the final tests are still to be completed. This sum being offered is well in excess of the cost of the product’s development, but the company’s management have decided to delay their response to the offer until the result of the investment evaluation is available.
The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by some new product that are constantly being introduced as the underlying technology evolves. In the first year it is anticipated that 35,000 units will be sold at a price of £152. From year two through to year four sales are expected to be 45,000 units per annum, but are expected to fall back to 35,000 units in year five.
The product will be manufactured in one of the company’s factories that has considerable spare capacity: it is most unlikely that the space required by the manufacture of this product will be required for any other purpose over the next five years. For the company’s internal accounting purposes all products are charged for the factory space that they utilise and this will amount to £50,000 per annum. The additional costs incurred by the company in the form of heating, lighting and power only amount to £30,000 per annum.
The machinery required for the manufacture of the product will cost £1,200,000. It will have to be depreciated for tax purposes on the basis of an annual 25 per cent writing down allowance (ie. 25 per cent of the remaining book value of the asset, the initial purchase price less the sum of the allowances claimed in previous years). At the end of the five year period the machinery will be sold or retained for use in the manufacture of other products. The resale value of machinery of this nature after being used for five years is likely to be about 30 per cent of its purchase price.
Use will also be made of some equipment already owned by the company. This could be sold today for £70,000 and is expected to maintain its resale value even if it is used for the next five years. This equipment is fully depreciated for tax purposes – it has a zero book value – but is still in good working order.
The cost of the labour and components required for the manufacture of the product has been estimated at £120 per unit for the first year, with labour accounting for 60 per cent of the cost and the components for the other 40 per cent. There are also fixed costs of £150,000 per annum stemming from the manufacturing process. The product will also be charged an allowance for general overheads through the management accounting system and this is set at 5 per cent of a product’s annual revenues. The overheads include the head office expenditure and the company’s expenditure on new product development – an important expense for the company. The initial marketing of the product will cost £200,000.
It is anticipated that the company will have to invest in working capital – holding finished products equivalent to 20 per cent of next year’s unit sales, 25 per cent of the components required for the next year, and it is expected that debtors and creditors will just about offset each other. The tax rate is 30 per cent and the required rate of return on investments of this nature is 14 per cent.
a) Determine the investment’s net present value, the internal rate of return, payback period and the discounted payback period. All key assumptions should be specified and explained and an interpretation provided of results for each of the investment criteria specified. You should identify and explain the costs and benefits that you think should be included in a rational decision making process.
On the basis of your analysis above, make a suitable recommendation for the company’s top management explaining the rationale behind it. (HINT : a good answer should clearly explain each figure used in the analysis – used or not).
b) Assess how sensitive the calculated NPV is to three inputs employed in the analysis. Provide an interpretation of your results and comment on how valuable you think this analysis may be in taking a decision on the investment. Apart from the sensitivity analysis, use another one method (choose from scenario analysis, Monte Carlo simulation, BEP analysis) to assess your capital budgeting analysis and findings. Compare the methods used in reference to their risk probability.
c) Assume that the annual rate of inflation is expected to be 4 per cent per annum for the next five years. Also assume that the required rate of return of 14 per cent you employed above is a market determined rate and incorporates an allowance for the expected rate of inflation of 4 per cent. Explain how you would take the expected rate of inflation into account in a revised analysis. (Part (a) of the question should be completed on the basis that the expected rate of inflation is zero.) Rework the NPV analysis of part a) under the revised rate and comment on your findings.
(TOTAL 20 MARKS)
. Company Valuation
a) Raglan Stores PLC has grown rapidly since its stock market flotation five years ago. Despite its rapid growth the company has been able to finance all its new development from retained earnings and employs no debt in its capital structure. The company’s earnings for the year that has just ended was 80€ MILLION, a new high, and with 200 million shares outstanding this produced EPS (earnings per share) of 40p. Last year the company re-invested 80% of its earnings and recorded a rate of growth of earnings 32%, well above the minimum rate of return of 20% sought by investors in its sector of the market. Exactly this growth is also expected for next year for the earnings.
The company has now opened stores in all the larger cities in the UK and new stores it plans to open will be located in towns with smaller markets that will produce lower turnover and profits per store. For the next 4 years or so it is anticipated that expansion will continue to be profitable, but less so than in the past even if the process is managed with the same degree of efficiency that has characterised the company’s development over the last few years. As the coverage of the UK market becomes more complete it is planned to reduce the amount of annual investment. It is anticipated that the company will again invest 80% of its earnings next year, 60% of its earnings the following year and 40% the subsequent year.
It is expected that the rate of return on new investment will fall to 35% next year, 30% the year after, and 25% three years from now. After the next three years management believes that there is unlikely to be scope for any investment offering internal rates of return of more than 20%. With the disappearance of opportunities for profitable growth it is intended in 4 years time to increase the dividends to 75% of earnings.
1. Estimate the value of the company using both the dividend and earnings based models, as well as the current price of the company’s shares. Set out the assumptions on which the models are based and discuss how appropriate they appear to be in this context. Determine the contribution of Growth opportunities to the estimated value of the company. (8 marks)
2. How would the value of the company change if the required Rate of Return was 15% ? Alternatively
if it was 25% ? Comment on your reply. (2 marks)
3. Determine the expected price/earnings ratio today. Explain the determinants of the PE in reference
to the two valuation models used. (3 marks)
4. A member of the board suggests identifying an appropriate price-earnings ratio for Raglan Stores and using this as a multiplier to derive a value for the company. Comment on this suggestion.
5. The government issued a 15 year bond offering an interest rate of 12 per cent 10 years ago. Since then interest rates have fallen sharply. The bond now has five years to run to maturity and the government has just issued a five year bond offering an interest rate of 6 per cent. Determine a value for the bond that has five years to run to maturity, assume the bond has a face value of £100 and
interest is paid annually. Explain your answer. (5 marks)
4. Portfolio Theory and Analysis
The attached file (MFR & FFM Ass Returns Data.xls) gives 120 months returns for securities drawn from the FT ALL share index as well as the returns on the FT ALL share index for the period January 2009 and December 2018.
a) Choose any five securities at random and determine the average returns for each company for the 120 months along with the variance and standard deviation of these returns. Next construct an equally weighted portfolio made up of the five securities, and determine the series of monthly returns. On this basis determine the average return for the portfolio and the associated variance and standard deviation. The averages, variances, and standard deviations can be derived using the relevant Excel functions. Utilise the Excel specification for population variance and standard deviation – STDEVP and VARP – in the calculations. Explain the discuss the relationship between the average returns, average variance, and average standard deviation for the five securities and the average returns, variance, and standard deviation for the portfolio. (4 marks)
b) Calculate the co-variances for each pair of securities in the portfolio and on the basis of this information, and using the relevant portfolio equations, calculate the standard deviation of the returns on the portfolio using the equally weighted portfolio risk equation. Compare your results to those obtained for the portfolio in part i above. Comment and explain your findings.
c) Choosing securities at random form equally weighted portfolios of 2, 5, 10, 15 and 20 securities determine the standard deviation of these portfolios and plot the standard deviations against the number of securities in the portfolios. Comment on your results and compare these with the results of the studies of naïve diversification. (In undertaking this analysis you can derive the results for each of the portfolios using the Excel spreadsheet – there is no need to employ the portfolio equations and estimates of co-variances etc.
d) Choose 2 companies from different sectors of economy and determine the beta of each one security by regressing the returns for the share on the returns for the FT ALL Share Index (the last column in the spreadsheet). Comment on what the value of the beta (the slope coefficients in the regression) indicates.
i. Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies. ii. Discuss the primary determinants of a share’s beta. (This part of the questions relates to
betas in general and does not require you to focus on the companies analysed in parts a,
b and c)
(Approximately 500 words) (8 MARKS)
(TOTAL 20 MARKS)
. Derivatives – Efficient Market Hypothesis
You are given the following data for a listed company as follows:
Options Traded on Legal and General
Share Price Exercise Price Calls Puts
Sep Dec Mar Sep Dec Mar
65.90 64 4.50 7.75 9.75 3.50 6.75 8.75
68 3.50 5.75 7.75 5.75 8.75 10.75
a) Draw a profit diagram for an investor in a call option with an exercise price of 64 that expires in March and explain the diagram. Undertake the same analysis for the writer of the call. Comment on the contention that options are a zero sum game for the writer and investor in options.
b) Explain carefully why the March calls are trading at higher prices than the December calls.
c) Draw a diagram illustrating a straddle, using calls and puts expiring in March and an exercise price of 64. Explain why an investor might consider it worthwhile to invest in a straddle and comment on the expected profitability of such an investment.
d) Explain what is meant by forward contracts and futures using examples. List the main advantages / disadvantages for their use.
e) Explain what is meant by the efficient market hypothesis and how tests of the hypothesis are
structured (3 marks)
f) Discuss the implications of the efficient market hypothesis for financial
managers and security analysts. (3 marks)
(TOTAL 20 MARKS)
6. Rights Issues – Long term Financing
Santa PLC is an all equity financed company with 100 million shares outstanding trading at €2 per share. Its management has decided to invest in a major new development that will cost € 40 million, and is now considering ways to finance the investment. Various alternatives have been considered but the choice has been narrowed down to a rights issue or the issue of debentures (a kind of bond).
The rights issue would be made at a discount of 20% and be underwritten at a cost of 2% of the proceeds. The company’s chairman has discussed the proposed investment and its prospects as well as the financing possibilities, quite openly with various institutions and the financial press. As a result it is likely that the share price already reflects the implications of the company’s proposed investment.
a) Determine the terms of the right issue, the ex-rights price and the theoretical value of the right.
b) Demonstrate that in principle the shareholders will be equally well off by subscribing to the issue or by selling their rights. Assume the shareholder has 100 shares. (3 marks)
c) Explain the impact on the value of the right if the issue is undertaken on the specified terms and the share (cum-rights) price falls to € 1.8 shortly after the shareholders are invited to subscribe to the new issue. (2 marks)
d) Would a deep discount without underwriting be preferable to save the expense of the underwriting fees ? Management considered the possibility but decided against it as it would have resulted in the dilution of EPS. Comment on the view taken by the management.
e) Evaluate the contention that the shareholders’ can expect an earnings yield of 30% on shares bought given a rights issue at a discount of 20%, and that this suggests a relatively high cost of capital. (2 marks)
f) The cost of underwriting is sometimes assessed in terms of the costs of an equivalent PUT option.
Explain and discuss this approach. (3 marks)
g) Explain and assess the view that rights issues are designed to protect the interests of
shareholders. (2 marks)
(TOTAL 20 MARKS)
. Capital Structure – MM proposition
a) A firm that has employed no debt in its capital structure in the past is considering financing a major investment programme of €1m. The firm examines two ways of financing – either by the issue of new shares or by issuing debentures. It has been advised by its merchant bankers that the bonds could be arranged at an interest rate of 10 per cent. The alternative would be an issue of equity of 250,000 shares at €4 per share. This would increase the number of shares outstanding from 500,000 to 750,000. After implementing the investment programme the firm expects earnings before interest and tax of €900,000. Given a tax rate of 35 per cent:
i. Calculate earnings per share for the debt and equity financing options at the expected earnings.
ii. Calculate the level of earnings at which the two financing options will offer the same EPS.
iii. Draw a “rough” graph of EPS as a function of the earnings before interest and tax for the two options.
b) i) Using the Miller-Modigliani model with taxes determine the value of the company for both the Ungeared and geared financing options, and comment on your assumptions.
Assume a revised share price following the Issue of the new shares of € 3.5/share. Provide estimates of the cost of capital for the company for the different financing plans and comment of your assumptions.
ii) Explain what is meant by the company’s weighted average cost of capital.
iii) Explain the contention that in the absence of the tax advantages of debt the use of gearing can increase the expected rate of return for shareholders, but not necessarily increase the value of their investment
(Total 20 marks)
(TOTAL 100 MARKS)