Exam May 2012, answers PDF

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Examination:Summer 2012FINANCIAL MANAGEMENTSpecimensolutionsOutlinemarkingschemein redTurnOverPage2 of 17----------------------------------------------------------------------------------------------------------------SECTION AAnswer ALLof the questionsin this sectionEachquestionis worth 2marksQuesti...

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---------------------------------------------------------------------------------------------------------------SECTION A

Examination: Summer 2012 FINANCIAL MANAGEMENT

Answer ALL of the questions in this section Each question is worth 2 marks ----------------------------------------------------------------------------------------------------------------

Specimen solutions

Question 1

Outline marking scheme in red

A firm’s share price has decreased over the past week. What is the best forecast that one can make about the share price during the coming week? (a) (b) (c) (d) (e)

The share price will reverse all of last week’s losses and more. The share price will continue last week’s decline. The share price will not change until new information is released. The share price is equally likely to increase or decrease. The share price is more likely to decrease than increase.

(2 marks) ---------------------------------------------------------------------------------------------------------------Question 2 Which of the following could be the reason why a capital project has a genuinely positive net present value? (i) Opportunities to exploit project flexibility. (ii) First-mover advantage. (iii) Favourable borrowing opportunities. (a) (b) (c) (d) (e)

(i) only. (i), (ii) only. (i), (iii) only. (ii), (iii) only. (i), (ii) and (iii). (2 marks)

Investment and financing decisions are separate. Shareholder value is created by what the company does compared to its competitors with the assets that it owns. ----------------------------------------------------------------------------------------------------------------

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Question 3

Question 5

Assume the real risk-free rate of return equals 1% and the real market risk premium equals 4%. If the expected inflation rate is 3%, what is the nominal required rate of return on the market? All rates are annualised rates.

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

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

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

8.00% 8.03% 8.15% 11.00% 11.15%

Its beta will increase. Its beta will decrease. Its price will increase. Its price will decrease. Its price will not change. (2 marks)

(2 marks) The required rate of return on the market equals the sum of the risk-free rate and the market risk premium. In real terms: r  1%  4%  5% The nominal rate of return R is related to the real rate of return r via Fisher’s relation: 1 R  (1 r )  (1  i ) 

1  0.05 1  0.03

 1.0815

R  8.15% ----------------------------------------------------------------------------------------------------------------

Question 4 A firm that uses its weighted average cost of capital to evaluate projects, regardless of how risky those projects are, will tend to: (a) (b) (c) (d) (e)

become less risky over time. become more risky over time. accept only low-risk projects. accept only average-risk projects. accept only high-risk projects.

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. --------------------------------------------------------------------------------------------------------------Question 6 If the marginal reduction in re-ordering costs exceeds the marginal increase in storage costs, then the firm: (a) (b) (c) (d) (e)

has minimised its re-ordering costs. has minimised its storage costs. has minimised its total costs. should increase its order size. should decrease its order size.

(2 marks) Storage costs increase (linearly) with increasing batch size Q. Re-ordering costs decrease with increasing batch size Q. The Economic Order Quantity is the batch size Q for which the marginal increase in storage costs equals the marginal decrease in re-ordering costs.

(2 marks) The firm will tend to: - reject low-risk projects with low betas and lower required rates of return than the WACC. - accept high-risk projects with high betas and higher required rates of return than the WACC.

For values of Q less than EOQ, the marginal increase in storage costs is less than the marginal decrease in re-ordering costs. For values of Q greater than EOQ, the marginal increase in storage costs is greater than the marginal decrease in re-ordering costs. ----------------------------------------------------------------------------------------------------------------

The firm will therefore become more risky over time. ---------------------------------------------------------------------------------------------------------------

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The amount of corporate tax that the firm pays therefore equals:

Question 7

30%  (EBIT  560,000)

The announcement of a rights issue is usually followed by an immediate fall in the firm’s share price. One possible explanation for this empirical observation is that:

What’s left after interest and corporation taxes have been paid belongs to the shareholders: (a) (b) (c) (d) (e)

the supply of the firm’s equity outstrips the demand for the firm’s equity. the firm’s managers know that the rights issue is over-priced. the firm has no positive-NPV investment opportunities. the firm’s underwriters charge too much. the stock market is inefficient.

EBIT  560,000  0.3  (EBIT  560,000) 

(1 - 0.3)  (EBIT  560,000)

In order to satisfy the shareholders, this surplus cash flow must equal: 14%  10,000,000  1,400,000

(2 marks) Storage costs increase (linearly) with increasing batch size Q. Re-ordering costs decrease with increasing batch size Q.

Hence:

The Economic Order Quantity is the batch size Q for which the marginal increase in storage costs equals the marginal decrease in re-ordering costs.

1,400,000  560,000  2,560,000 1 - 0.3 ---------------------------------------------------------------------------------------------------------------

For values of Q less than EOQ, the marginal increase in storage costs is less than the marginal decrease in re-ordering costs. For values of Q greater than EOQ, the marginal increase in storage costs is greater than the marginal decrease in re-ordering costs. ---------------------------------------------------------------------------------------------------------------Question 8

Question 9 Which of the following is most likely to result in an increase in the value of a company’s shares? (a)

A firm has £10 million in equity and £7 million in debt in its capital structure. Both values are market values. Its cost of equity equals 14% and its cost of debt equals 8%. The corporate tax rate equals 30%. How large must the firm’s operating cash flow before interest and tax be in order for the firm to satisfy both its lenders and its shareholders? (a) (b) (c) (d) (e)

(1 - 0.3)  (EBIT - 560,000)  1,400,000  EBIT 

£1,792,000 £1,960,000 £2,560,000 £2,800,000 None of the above. (2 marks)

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

The company announces that its long-awaited contract with the Government has now been agreed, and production will begin soon. As a result of a change in its depreciation policy, the earnings figure in the company’s annual report is double the figure for the previous year. The company’s main competitor announces a price cut. The company announces an unexpectedly large increase in its dividend. The company announces a hostile bid for another company. (2 marks)

The market usually interprets an increase in the dividend as a signal that the company is confident about its ability to sustain the dividend per share at the higher rate. The share price will change because the size of the increase is unexpected. (a) is not news as the contract has been expected for some time. (b) earnings are subjective. (c) the company is likely to lose market share as a result of its competitor’s price cut. (d) the company is likely to pay a significant bid premium to secure the deal. ----------------------------------------------------------------------------------------------------------------

Denote the firm’s operating cash flow before interest and tax by EBIT. The amount of interest that the firm’s has to pay on its debt equals: 8%  7,000,000  560,000

Since interest payments on debt are corporate-tax deductible, the firm’s taxable income is obtained by first subtracting this interest payment of £560,000 from the firm’s operating cash flow.

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---------------------------------------------------------------------------------------------------------------SECTION B

Question 10 The nominal one-year risk-free rates in the UK and Japan are 1.25% and 0.75%, respectively. If the spot exchange rate is 139.35 Japanese yen per pound sterling, what is today’s best forecast of the exchange rate (in yen per pound sterling) in 12 months’ time? (a) (b) (c) (d) (e)

138.66 139.35 140.04 140.40 141.09

Answer ANY TWO questions in this section Each question is worth 40 marks ---------------------------------------------------------------------------------------------------------------Question B1 – ANSWER BOTH PARTS OF THIS QUESTION (a)

(i) List four characteristics of a Modigliani & Miller (1958) perfect world. (4 marks)

(2 marks) The one-year forward exchange rate is an unbiased forecast of the future spot rate one year from now.

(ii) State Modigliani & Miller’s (1958) Proposition I. What determines the market value of a firm in a Modigliani & Miller (1958) perfect world? (4 marks)

The interest-rate parity theorem gives:

F

¥/£

 1  RJapan     S   ¥/£  1  R UK 

 1 0.0075 248.68     236.92   1 0.0575 

where S¥/£ and F¥/£ are the spot and forward exchange rates (in yen per pound sterling), respectively. ----------------------------------------------------------------------------------------------------------------END OF SECTION A

(iii) Show from first principles that Modigliani & Miller’s (1958) Proposition I implies that the cost of equity increases linearly with the ratio of debt to equity. Provide an intuitive interpretation of this result. (12 marks) (i) In a Modigliani & Miller (1958) world: -financial markets are perfectly efficient1. -there is no information asymmetry i.e. everyone has the same information set1. -there are no taxes 1. -there are no transactions costs1. (ii) MM Proposition I states: in an MM perfect world0.5, capital structure is irrelevant0.5. In an MM (1958) perfect world, the market value0.5 of a firm depends only0.5 on its capital investment policy 0.5 i.e. the capital projects0.5 in which it invests. Only the uses0.5 , not the sources0.5, of financing matter. (iii) The WACC is a weighted average of the firm’s cost of debt capital RD and cost of equity capital RE. The weights reflect the proportions (by market value) of equity and debt in the firm’s capital structure. Hence:

WACC



D  RD  D E

2 E  RE D E

This can be re-written (after some algebra) as: R

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E

 WACC  (WACC  R )  D

D 2 E

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In a Modigliani-Miller (1958) world0.5 , capital structure is irrelevant0.5 . This implies that the WACC is constant0.5, regardless of the debt/equity ratio D/E.0.5 0.5

Question B1 – ANSWER BOTH PARTS OF THIS QUESTION (b)

(i)

What is a share buy-back? (2 marks)

0.5

If, in addition, we assume that debt is risk-free , then RD is also constant . Since the shareholders0.5 then support all of the risk0.5 of the firm, they require a higher rate of return0.5 than do the lenders0.5. Thus, the weighted average cost of capital is greater than the cost of debt0.5 , and therefore WACC - RD > 00.5.

(ii)

Why might firms buy-back some of their shares? Explain. (8 marks)

(iii) A UK company has 500 million shares outstanding, trading at 90p each. Its earnings last year were £30 million.

The above equation is therefore that of a straight line0.5 with intercept = WACC0.5 and positive0.5 slope equal to (WACC – RD)0.5 :

The firm decides to re-purchase 100 million shares at 90p per share. Required Return

Calculate its new share price. RE

State any assumptions that you make. (10 marks) (i) Share buy-backs are an alternative to special dividends as a means of distributing cash to shareholders0.5. Managers who aim to maximise shareholder wealth may want to do this if they are unable to earn a higher rate of return than the shareholders can achieve by investing the capital themselves in the financial markets. 0.5

WACC RD D/E

Share buy-backs were introduced in the UK following the 1981 Companies Act, but have existed for much longer in the US, where they are known as stock repurchases. In the UK, shares that are bought back are typically annulled0.5 (although they no longer need be), whereas in the US they are held by the firm in its Treasury account (and can subsequently be re-activated0.5 e.g. when managers exercise their executive stock options). (ii)

[Students are not expected to include all of the points below. Hence, the marks listed add up to more than 8 marks]. A company’s share price usually0.5 (but by no means always) increases0.5 in response to the announcement of a share buy-back. Managers therefore favour share buy-backs, since any executive stock options0.5 that they own become more valuable0.5 as a result. In the absence of taxes0.5 and transactions costs 0.5, shareholders should be indifferent0.5 between receiving cash in the form of dividends or via a share buy-back. In practice, the tax authorities treat the gain made by shareholders who sell shares back to the company at a higher price0.5 than they originally paid for them0.5 as a capital gain 0.5 , not income. Since tax-payers pay capital-gains tax (CGT) 0.5 only on gains that exceed their annual CGT allowance0.5 , there is a tax incentive0.5 for companies to distribute cash to their shareholders via a share buy-back rather than as dividends. Share buy-backs reduce the number of shares outstanding0.5 without at the same time reducing the company’s overall earnings0.5. Therefore, the firm’s earnings per share are increased0.5 by buying back shares.

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Page 11 of 17 Managers can use a share buy-back – funded by taking on more debt0.5 - to signal0.5 that they are confident about running the company with a higher gearing ratio0.5 . If the company pays corporation taxes, it will benefit from the tax shield of debt.0.5 (iii) Earnings per share before the share buy-back: eps 

1 30,000,000  0.06 i.e. 6p per share 500,000,000

Earnings per share immediately after the share buy-back: eps



30,000,000 400,000,000



Page 12 of 17 Question B2 – ANSWER BOTH PARTS OF THIS QUESTION (a)

A company has to decide now whether to invest in a new piece of machinery or not. The machine in question costs £28,000 to buy and is expected to have a working life of five years. Its scrap value five years from now is £1,000. Cash flows from operations are expected to be £10,000 in each of the five years. If the company decides to buy the machine now, it will also have to increase its working capital by £8,000. This working capital will be recovered at the end of the five years. The company pays sufficient tax on all of its operations to absorb all capital allowances, which are calculated on a 25% reducing-balance method. The first capital allowance can be taken straightaway.

1 0.075 i.e. 7.5p per share

The (after-tax) cost of capital is 10% and the corporate tax rate is 30%. Ignore inflation. since the number of shares is reduced from 500 million to 400 million0.5. Thus, earnings per share increase0.5 as a result of the share buy-back. What happens to the share price depends on what we assume about the information content of the announcement of the share buy-back.0.5 We will assume that the announcement of the share buy-back conveys no new relevant information to the market.0.5 In this case, the market disregards the announcement of the share buy-back, and the share price is unaffected0.5. The share price therefore remains at 90p0.5 . Note that the share price would change if the shares were bought back at a price other than the prevailing market price of 90p.0.5

(i) Calculate the schedule of capital allowances that the company will enjoy if it buys the machine now. Pay particular attention to the timing of those capital allowances and to the size of the final capital allowance. (6 marks) (ii) Calculate the Net Present Value of buying the machine now and operating it for the duration of its working life. Should the company go ahead and buy the machine? Explain your answer. (8 marks) (iii) Would your answer to part (ii) change if there were no capital allowances? Explain. (6 marks)

The PE-ratio falls as a result of the share buy-back.0.5 (a) (i)The written-down value of the machine after t years is given by 28,000 (0.75)t .1

PE-ratio before the announcement of the share buy-back:

P E



The first allowance equals 25% of 28,000 = 7,000 and is taken immediately0.5 .

1 0.90  15 0.06

The balancing allowance at the end of Year 5 is given by the difference0.5 between the written-down value of the machine = 28,000 (0.75)5 = 6,645 and its scrap value of 1,0000.5 i.e. 5,645.

PE-ratio immediately after the announcement of the share buy-back: P E



0.90 0.075

 12

1

0.5

0.5

The implication is that the company is expected to grow less rapidly following the share buy-back. If the company has used retained earnings to fund the share buyback0.5, the implication is that it has only so many positive-NPV projects 0.5 in which to invest. If this is true, then growth will slow. ---------------------------------------------------------------------------------------------------------

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Book value Capital allowance

0 28,000 7,0000.5

1 21,000 5,2500.5

End of Year 2 3 15,750 11,813 3,938 0.5 2,9530.5

4 8,859. 2,2150.5

5 66450.5 5,6450.5

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Page 14 of 17 Question B2 – ANSWER BOTH PARTS OF THIS QUESTION

(ii)

Corporate tax equals 30% of taxable income. Taxable income in turn equals the difference between operating cash flow and capital allowance:

0 Operating CF Capital allowance Taxable income1 1 Corporate tax

-7,000 -7000 -2,100

1 10,000 -5,250 4,750 1,425

End of Year 2 3 10,000 10,000 -3,938 - 2,953 6,062 7,047 1,819 2,114

4 10,000 -2,215 7,785 2,336

(b)

...