Exam March 2013, answers PDF

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Classtest:March 2013FINANCIAL MANAGEMENTSpecimensolutionsTurnOverAnswer ALLquestionsEachquestionis worth1 markQuestion 1If investorscan consistentlyprofit fromanalysing published financialinformation,thenthe marketcan, at best, becharacterisedas:(a) weak-formefficient. (b) semi-strong-formefficient....

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Answer ALL questions Class test: March 2013

Each question is worth 1 mark

FINANCIAL MANAGEMENT Question 1 If investors can consistently profit from analysing published financial information, then the market can, at best, be characterised as:

Specimen solutions

(a) (b) (c) (d) (e)

weak-form efficient. semi-strong-form efficient. strong-form efficient. inefficient. Impossible to say without knowing more about the published information.

(1 mark) ---------------------------------------------------------------------------------------------------------------Question 2 A company is selling a machine for £10,000 that it originally bought five years ago for £100,000. Assume that capital allowances are calculated on a 25% reducing-balance basis, and that the company pays corporate taxes at 30 per cent. Assume that the company has sufficient taxable income to absorb all of its capital allowances. What is the effect of this disposal on the company’s tax payment for this year? (a) (b) (c) (d) (e)

Increases by £7,120 Increases by £4,120 Decreases by £4,120 Decreases by £7,120 Decreases by £13,730 (1 mark) 5

Written-down value of machine after five years = 100,000 x (0.75) = 23,730. Balancing allowance = 23,730 – 10,000 = 13,730. Tax credit = 13,730 x 0.30 = 4,119 ----------------------------------------------------------------------------------------------------------------

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Page 3 of 9 Question 5 Question 3 In project appraisal, an increase in net working capital can be modelled as: Which one of the following incremental cash-flow forecasts is most likely to result in an increase in shareholder value? (a) (b) (c) (d) (e)

One that reflects the exploitation of a competitive advantage. One that indicates a short payback period. One that indicates a positive net present value. One that indicates a high internal rate of return relative to the hurdle rate. One that indicates a high accounting rate of return relative to the return on capital employed. (1 mark)

Bias in cash-flow forecasts could be the reason why the NPV is positive or the IRR is greater than the hurdle rate.

(a) (b) (c) (d) (e)

a cash inflow at the beginning of the project only. a cash outflow at the beginning of the project only. a cash inflow at the beginning and an equal cash outflow at the end of the project. a cash outflow at the beginning and an equal cash inflow at the end of the project. a decrease in the initial amount invested. (1 mark)

The investment in working capital at the beginning of a capital project is modelled as a negative cash flow. The working capital that is sold off at the end of the project is modelled as a positive cash flow. In the absence of inflation, the changes in working capital are equal and opposite. ----------------------------------------------------------------------------------------------------------------

Payback takes no account of the time value of money and considers only the cash flows that occur during the payback period.

Question 6

Accounting rate of return is based on accounting profits and book values, both of which are subjective.

Which one of the following statements (a) – (d) is true of a firm that uses its WACC as the hurdle rate for appraising all of its capital projects, regardless of how risky those projects are?

A genuine positive NPV reflects the company’s ability to extract economic rent by exploiting some form of competitive advantage in the relevant product or services market.

(a) (b) (c) (d) (e)

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The firm’s operations will tend to become less risky over time. The firm’s operations will tend to become more risky over time. The firm will likely see its WACC fall over time. The firm will accept only projects for which the IRR equals the WACC. None of the above statements (a) – (d) is true. (1 mark)

Question 4 The Main Board of Company B invites two of its managers to rank a set of capital projects. Manager X uses the Net Present Value method, whereas Manager Y uses the Profitability Index. Which of the following statements is true?

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(a) (b) (c)

What is expected to happen to a security that offers a higher risk premium than that predicted by the Securities Market Line?

(d) (e)

X and Y agree on which projects should be undertaken only if capital is rationed. X and Y agree on which projects should be undertaken only if capital is not rationed. X and Y always agree on which projects should be undertaken, regardless of whether capital is rationed or not. X and Y never agree on which projects should be undertaken. None of the above statements is true. (1 mark)

If capital is not rationed, then both the NPV and the Profitability Index will be positive for each project that adds value for shareholders. Each of these projects will be accepted, regardless of whether the NPV or the Profitability Index is used.

Question 7

(a) (b) (c) (d) (e)

Its beta will increase. Its beta will decrease. Its price will increase. Its price will decrease. Its price will not change. (1 mark)

Question 7 in the problem sheet on Project Appraisal is an example of how the Profitability Index and the NPV can appear to rank two projects differently when capital is rationed.

Such a security is under-priced relative to its fair value and therefore plots above the Securities Market Line. The resulting excess demand for the security will drive up its price, and in the process reduce the rate of return that it is expected to provide. The point representing the security will therefore fall back down towards the Securities Market Line.

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Question 8 Company C maintains an average level of 15,000 units of inventory throughout the year. Storage costs equal £9 per item. The firm orders 30,000 units each month, and incurs a fixed charge of £200 each time it re-orders. How large is the economic order quantity? (a) (b) (c) (d) (e)

1,250 units. 2,000 units. 2,400 units. 4,000 units. 7,500 units.

2,000,000  5 400,000 ----------------------------------------------------------------------------------------------------------------

Question 10 (1 mark)

The economic order quantity EOQ is given by the formula: 2 N  R C



2 360,000 200 9



What is the value of a right? (a) (b) (c) (d) (e)

The total number of units per year equals 12 x 30,000 = 360,000.

EOQ 

This number of new shares is allocated pro rata amongst the existing 2,000,000 shares. Hence, the number of existing shares that shareholders must own in order to qualify for the right to buy one new share is:

£0.25 £0.30 £0.35 £1.75 None of the above. (1 mark)

16,000,000  4,000

where N = total number of units per year, R = re-ordering costs and C = storage cost per unit.

The value of the right to buy one new share equals the difference between the ex-rights price Sex and the issue price I: R  S ex  I

---------------------------------------------------------------------------------------------------------------The ex-rights price Sex is obtained by solving the equation: The following information applies only to Questions 9 and 10. N  S cum

A firm needs to raise £600,000 via a rights issue. There are 2 million shares outstanding, trading at £1.80 per share. The issue price is £1.50 per share.

 I

 ( N 1)  S ex

Substitute Scum = 1.80, I = 1.50 and N = 5:

Question 9 How many rights are required to purchase one new share?

5 1.80 

(a) (b) (c) (d) (e)

 S ex

3 4 5 6 None of the above.

1.50  6  S

ex



10.50  1.75 6

Hence, the value R of a right to buy one new share: (1 mark)

R  1.75  1.50  0.25 ----------------------------------------------------------------------------------------------------------------

The number of new shares to be issued equals: £600,000 £1.50

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E UnG



250,000  0.12

2,083,333

---------------------------------------------------------------------------------------------------------------Question 11 According to Myers’ (1984) pecking-order hypothesis, which of the following are reasons why managers might choose to raise debt in preference to new equity? (i) The costs of issuing debt are less than the costs of raising equity. (ii) The requirements regarding disclosure of commercially-sensitive information are less stringent for debt origination than for equity origination. (iii) To dilute the firm’s earnings per share. (a) (b) (c) (d) (e)

(i) only. (i) and (ii) only. (i) and (iii) only. (ii) and (iii) only. (i), (ii) and (iii).

Question 13 What is the value of Geared plc? (a) (b) (c) (d) (e)

£1,250,000 £1,500,000 £2,083,333 £2,375,000 £2,458,333 (1 mark)

(1 mark) ----------------------------------------------------------------------------------------------------------------

The market value of Geared plc exceeds the market value of Ungeared plc by the value of the corporate tax shield of debt. The value of the tax shield is: TC  D  0.30 1,250,000

 375,000

The following information applies only to Questions 12 and 13. Assume a Modigliani-Miller (1963) world in which the corporate tax rate is 30%.

Hence, the market value of Geared plc equals:

Ungeared plc and Geared plc each have annual net operating cash flows of £250,000 in perpetuity and identical business risks. Ungeared plc is all-equity financed. Its cost of equity capital equals 12%. Geared plc has both equity and debt in its capital structure. Its debt has a market value of £1.25 million and pays an annual coupon of 8%. Assume that each company distributes all of its surplus earnings as dividends. Question 12

 VUngeared

 TC  D 

2,083,333 375,000  2,458,333

Question 14 Assume a Modigliani & Miller (1958) perfect world. Company Y has a fixed capital investment policy and is part-equity, part-debt financed. Which of the following will increase if the firm decides to replace some of its equity with debt?

What is the value of Ungeared plc? (a) (b) (c) (d) (e)

VGeared

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£1,250,000 £1,500,000 £2,083,333 £2,375,000 £2,458,333

(i) The variability of the firm’s earnings per share. (ii) The firm’s operating risk. (iii) The firm’s weighted average cost of capital (WACC). (1 mark)

The market value of Ungeared plc is given by the present value of its expected future dividends. This in turn equals the present value of its net operating cash flows since the firm distributes all of its surplus earnings as dividends.

(a) (b) (c) (d) (e)

(i) only. (ii) only. (i) and (ii) only. (ii) and (iii) only. (i), (ii) and (iii).

(1 mark) ----------------------------------------------------------------------------------------------------------------

Since these cash flows form a perpetuity:

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Question 15 All other things being equal, which of the following might be a reason why an investor would prefer owning shares in firms with high dividend payouts? (i) The investor needs cash. (ii) The investor is not a higher-rate taxpayer. (iii) The costs of raising new finance are significant. (a) (b) (c) (d) (e)

(i) only (ii) only. (i) and (ii) only. (ii) and (iii) only. (i), (ii) and (iii).

(1 mark) ----------------------------------------------------------------------------------------------------------------

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