Exam 2015, questions and answers PDF

Preview

Summary

Download Exam 2015, questions and answers PDF

Description

Department of Accounting and Finance M.Sc. Finance M.Sc. Investment and Finance M.Sc. International Banking and Finance M.Sc. International Accounting and Finance M.Sc. Finance and Management M.Sc. Economics and Finance and M.Sc. Quantitative Finance

AG910: Principles of Finance1 SAMPLE PAPER – SOLUTIONS 10.30am – 1.30pm (3 hours) Instructions for Candidates – Please Read Carefully Answer ALL Questions from Section A (in the spaces provided) and TWO Questions from Section B (in the answer book) 1. Financial calculators are not allowed. 2. Calculators must not be used to store text and/or formulae nor be capable of communication. Invigilators may require calculators to be reset. 3. All answers are to be written in the spaces provided in ink. If more space is required the answer can be continued on the back of the page where the question appears. 4. If you make use of more than answer book note this on the front of the script, ie. book 1 of … book 2 of … etc. 5. This question paper is to be returned along with your examination answer booklet, you should complete the above and slip this paper into your answer booklet. Under no circumstances is a copy of this paper to leave the exam room. 6. Failure to follow these requirements will lead to a deduction of marks.

To Be Issued: Discount Tables To Be Completed by Student (please write clearly)

Surname Forename Registration Number 2015 Course (please indicate by ticking appropriate box) Finance

1

Investment & Fin.

Int. Banking & Fin

Int. Accounting & Fin

Fin & Man

Econ & Fin

Quan. Fin

This exam accounts for 70% of your final mark in this class

AG910

1 of 10

For Examiners Use Only

SECTION A TOTAL MARKS AWARDED

AG910

2 of 10

Q1.

Section A Answer ALL Questions An investment of £80,000 is expected to produce a constant annual net cash flow of £21,710 for the next six years. a)

Determine the investment’s NPV if the required rate of return is 9 per cent. NPV

b)

=

(2 marks) -80,000 + 21,710 x PVAF6/.09 = -80,000 + 21,710 x 4.4859 = 17,389

Determine the approximate value of its IRR. (2 marks) NPV PVAF6/i PVAF6/0.16 i

c)

= = = =

0 = -80,000 + 21,710 x PVAF6/i 80,000/21,710 = 3.6849 3.6847 16 per cent (approximately)

Determine the approximate value of its payback period and discounted payback period and comment briefly on your results. (2 marks) 80,000 =21,710 x PVAF n|0.09 PVAF n|0.09=80,000/21,710 =3.6849 Solve for n use tables or 80,000 = 21,710 [1/0.09 x (1 – 1/1.09n)] 80,000/21,710( x 0.09 )= 1 – 1/1.09n 0.3316 = 1 – 1/1.09n 1 – 0.3316 = 1/1.09n 0.6684 = 1/1.09n n 1.09 = 1/0.6684 = 1.4962 n ln 1.09 = ln 1.4962 n = ln1.4962/ln1.09 = 4.68

d)

AG910

The management of a company that has decided to manufacture a new product is considering the price to charge for the product. As a first step it is decided to determine the price at which the company would breakeven in producing the product. The labour cost per unit is £4 and the material cost per unit us £12. The machinery required to manufacture the product will cost £60,000 and has the capacity to produce 3,000 units per annum for its 5 year life. Assuming the demand for the product is equivalent to the full capacity output determine the breakeven price if the required rate of return is 12 per cent and tax can be ignored. (3 marks) Annual Cost Capital = £60,000/3.6048 = £16,645 Unit Capital Cost = Annual Cost/Output = £16,645/3,000 = £5.55 Overall cost per unit = Labour cost per unit + Material cost per unit + Capital cost per unit = £4.00 + £12.00 + £5.55 = £21.55

3 of 10

Q2.

a)

Electronic Chips plc is expected to produce earnings of 36p per share next year and to pay out 50 per cent of its earnings as dividends. Its current share price is 450p. Shares of this risk are expected to yield 12 per cent. Determine the rate of growth Chips is expected to produce if its share price can be explained by the Gordon growth model and the proportion of the share price accounted for by its growth prospects. (3 marks) Gordon growth model P0 = D1 1/(r – g) r = D1/P0 + g g = r – D1/P0 Chips g = 0.12 – 18/450 = 0.12 – 0.04 = 0.08 Growth rate is 8 per cent PVGO = PG - PNG = 450 – 300 = 150 NG P = E1 1/r = 36 1/0.12 = 300 PVGO/P0= 150/450 = 1/3

b)

Brechin plc is expected to pay dividends per share of £5.00, £6.00 and £6.50 over the next three years. A dividend of £7.00 is expected to be paid in year four and in subsequent years it is anticipated that dividends will grow at 4.50 per cent per annum. If the required rate of return is 12.5 per cent determine a value for Brechin’s shares. Will the long term growth rate add value to the company if it is financed by retaining 30 per cent of its earnings? (Assume the constant rate of growth of dividends model.) (4 marks) 2 3 P0 = 5.00 (1/1.125) + 6.00 (1/1.125 ) + 6.50 (1/1.25 ) + 7.00 (1/0.125 – 0.045) 1/1.1253 g = 0.045 g = retention rate x rate of return 0.045 = 0.30 x i i = 0.15 i >r Therefore PVGO > 0

AG910

4 of 10

Q3.

AG910

Pyle Manufacturing has been offered a contract to supply some components to Tron Engineering for the next five years. The work could be undertaken in one of the company’s production plants that has considerable spare capacity. The components will be produced using machinery that it owns and has been planning to sell, but it would also be necessary to invest £4m in additional machinery. The existing machinery was bought five years ago for £12 million and has a remaining book value for tax purposes of £6 million. It has been depreciated for tax purposes on a straight line basis over an assumed working life of ten years, as required by the tax authorities. If sold now it is anticipated that it would realise £2.4 million. It would have no resale value if used to produce the components for the next five years. The new machinery would also be depreciated for tax purposes on a straight line basis over 10 years. It is expected to have a resale value of £0.8 million at the end of the project’s life. The project would also require an investment in working capital of £2 million. The contract would be for 4 million units a year at a price of £2.60 each. The cost of production estimated by the factory accountant, excluding the cost of the factory space and machinery, is as follows: Materials £0.40 per unit Labour £0.80 per unit Power etc. £0.20 per unit Overheads £0.40 per unit The overheads are allocated on the basis of direct labour costs. Is this a profitable investment if the required rate of return is 12 per cent and the tax rate is 40 per cent? (8 marks)

5 of 10

Q4.

Given the following variance-covariance matrix for five securities determine the risk of an equally weighted portfolio of the five securities. Assuming that the average variance and average covariance calculated on the basis of the five securities are representative of securities traded on the stock exchange as a whole discuss briefly the implications of your results. 1 2 3 4 5 Average variance Average covariance VAR (Rp) SD(Rp)

Q5.

1 370 163 149 187 195

2 163 460 220 90 228

3 149 220 410 140 116

4 187 90 140 290 132

5 195 228 116 132 470 (5 marks)

= (370 + 460 + 410 + 290+ 470)/5 = 400 = (163 + 149 + 187 + 195 + 220 + 90 + 228 + 140 + 116+132)/ 10 = 162 = 1/5 x 400 + (1 – 1/5) 162 = 80 + 129.6 = 209.6 = 14.48

The expected rate of return on the market portfolio is 16 per cent with a standard deviation of 20 per cent and the risk free rate is 6 per cent. Determine the composition of an efficient portfolio that offers an expected return of 8½ per cent. Determine the standard deviation of this portfolio and its beta. (2 marks) E(Rp) = (1 – wm)RF + wm E(Rm) 8.50 = (1 – wm)6 + wm 16 8.50 - 6 = 10 wm wm = 2.5/10 = 0.25 wm = 0.25 and wF = 0.75 SD(Rp) = wmSD(Rm) = 0.25 x 20 = 5 βp = wm = 0.25

Q6.

The expected return on security A is 20.4 per cent and its beta has been estimated at 1.20 whereas the expected return on security B is 14.4 per cent and it has a beta of 0.70. Determine the risk free rate and the expected return on the market, assuming the expected returns can be explained by the CAPM. (3 marks) E(RA) = RF + βA [E(Rm) – RF] (1) E(RA) = 20.4 = RF + 1.2 [E(Rm) – RF] (2) E(RB) = 14.4 = RF + 0.7 [E(Rm) – RF] [1 – 2] = 6.0 = 0.5 [E(Rm) – RF] 6.0/0.5 = 12.0 = [E(Rm) – RF] = risk premium Substitute in the equation for E(RA) E(RA) = 20.4 = RF + 1.2 x 12.0 RF = 20.4 – 14.4 = 6.0 Given E(Rm) – RF = 12.0 E(Rm) = 12.0 + 6.0 = 18.0

AG910

6 of 10

Q7.

The beta for the shares of Jardine plc has been estimated at 1.30, the expected return on the market portfolio is 15 per cent and the risk free rate is 6 per cent. In the year just ending the return on the market was higher than expected at 20 per cent. The return on the shares of Jardine was even higher at 31 per cent. Assess Jardine’s stock market performance over the last year. (3 marks)

E (R j ) RF   j (E (RM )  RF )  6  1.30(15  6) 17.70 E (R jt | RMt )  RF   j (RMt )  RF )  6  1.30(20  6) 24.20 AR jt R jt  E (R jt | R Mt )  31 24.20 6.80

Q8.

Gala plc has two divisions, one produces specialised radio equipment and the other components for electronic monitoring sets. The demand for radio equipment is steady but the demand for the components, produced in a more automated capital intensive process is highly cyclical. The radio division accounts for 70 per cent of the company’s business and the components division for the residual 30 per cent. Management is setting the cost of capital for these divisions. The risk free rate is 6 per cent and the expected return on the market is 15 per cent. The beta of the company’s shares has been estimated at 1.55 and the company is financed by 40 per cent debt and 60 per cent equity. There is a company quoted on the stock market that only produces specialised radio equipment and its shares have a beta of 0.8: this company is financed 75 per cent equity and 25 per cent debt. What rates of return should be set for the two divisions of Gala plc? (5 marks) Estimate the asset beta for radio manufacturer βA(B) = wE βE(B) = 0.75 x 0.8 = 0.6 assumes that the beta of the debt is zero Estimate overall asset beta for Gala plc βE(B) =1.55 = 1/wE βA = 1/0.60 x βA βA(A) =1.55 x 0.60 = 0.93 βA(A) is a weighted average of the betas for the radios and components and we have to determine the beta for radio equipment βA(A) 0.93 βA(components)

= wB βA(radio) + wB βA(components) = 0.7 x 0.6 + 0.3 βA(components) = [0.93 – 0.7 x 0.6]/0.3 = 1.7

Given the asset betas for radios and components the required rates of return can be estimated E(R(radios)) E(R(components))

AG910

= RF + βradio [E(Rm) – RF] = 6 + (15 – 6)0.6 = 11.4 = RF + βcomponents [E(Rm) – RF] = 6 + (15 – 6)1.7 = 21

7 of 10

Q9.

The cost of a call with an exercise price of 120p on a share currently selling at 102p is 16p. Determine the profit at the expiry date for a covered call for the following share prices and draw a profit graph to illustrate the profit outcomes. Share Prices Share Prices Profit

80

90

100

110

120

130

80

90

100

110

120

130

140 (3 marks) 140

-6

4

14

24

34

34

34

Profit + Capital Gain /Loss on Share

Covered call 34 16 102

Share Price 120

Written call Q10.

Using a one period binomial model and the following information derive a value for a call today: T = one period S0 = 120 SMAX = 150 r = 0.07 (for one period) X = 120 SMIN = 110 (3 marks)

Investment

Payoff

( HS0  C0 )(1  r )  HSMAX  C MAX HSMAX  C MAX (1  r ) 0.75x 150  30 77.1028 0.75x120  C 0  (1 0.07) C 0  0.75x 120  77.1028 12.897 (HS0  C0 ) 

(HS0  C0 )(1  r ) HS MIN  C MIN HSMIN  CMIN (1  r ) 0.75x 110  0  77.1028 0.75x120  C 0  (1  0.07) C 0  0.75x 120  77.1028 12.897 (HS0  C0 ) 

AG910

8 of 10

Q11.

Draw a profit graph for a long straddle and a long strangle and comment briefly on when these strategies might be employed. (2 marks) Profit +

Straddle Strangle

XSGL

XSD

XSGII

Share Price

(TOTAL 50 MARKS) [Please Turn Over] For Examiners Use Only

Page Total

AG910

Cumulative Mark

9 of 10

Section B Answer TWO Questions

Q1.

Explain and discuss the internal rate of return as an investment criterion, paying particular attention to the problems posed for its use by mutually exclusive investments and investments involving negative cash flows at the end of their lives. (25 MARKS)

Q2.

a)

Explain the constant rate of growth dividend model and discuss the insights it provides on the determinants of share values. (13 marks)

b)

Explain what is meant by the efficient market hypothesis and discuss the different forms of the hypothesis. (12 marks) (TOTAL 25 MARKS)

Q3.

“Diversification can reduce risk, but is unlikely to be able to eliminate risk.” Explain and discuss. (25 MARKS)

Q4.

Differentiate between the security and capital market lines and discuss the insights provided by both for the relationship between risk and return. (25 MARKS)

Q5.

a)

Explain and discuss the factors that are likely to affect the market values of call options. (15 marks)

b)

Explain what is meant by a protective put and develop an example to illustrate how it works. (10 marks) (TOTAL 25 MARKS)

End of Paper

AG910

10 of 10...