Exam May 2013, answers PDF

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Examination:Summer 2013FINANCIAL MANAGEMENTSpecimensolutionsSuggestedmarkingschemein redTurnOverAnswer ALLquestionsEachquestionis worth 2marksQuestion 1Whichof the followingstatementsaboutmarketefficiencyis/aretru e?(i) Weak-formefficiency relatesonlyto past pricepatterns. (ii) Semi-strong-form effi...

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Examination: Summer 2013

Answer ALL questions

FINANCIAL MANAGEMENT

Each question is worth 2 marks

Specimen solutions

Question 1

Suggested marking scheme in red

Which of the following statements about market efficiency is/are true? (i) Weak-form efficiency relates only to past price patterns. (ii) Semi-strong-form efficiency relates only to publicly available information other than past price patterns. (iii) Strong-form efficiency relates only to “insider” information. (a) (b) (c) (d) (e)

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

A market that is semi-strong-form efficient adjusts its prices immediately and correctly in response to new, relevant public information. Public information includes past prices. A market that is strong-form efficient adjusts its prices immediately and correctly to all forms of new, relevant information – both public and private information. ----------------------------------------------------------------------------------------------------------------

Turn Over

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Question 2

Question 3

Company X has to choose between undertaking Project A now or Project B in two years’ time. Both projects have the same expected future cash flows, but Project B will require a lower initial investment thanks to anticipated technological advances over the coming two years. Company X uses a cost of capital of 12% for both projects. The Net Present Value of Project A equals £500,000.

If the share price of a particular company consistently goes up (or down) by 1.5% when the market goes up (or down) by 1.2%, then its beta equals:

By how much must the investment cost of Project A exceed that of Project B for Company X to prefer to wait two years and invest in Project B? (a) (b) (c) (d) (e)

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

0.80 1.25 1.50 1.80 None of the above.

(2 marks) 1.5%  1.25 1.2% ----------------------------------------------------------------------------------------------------------------

£101,403 £127,200 £398,597 £500,000 None of the above.

β 

(2 marks)

Question 4 Which of the following should not be included in storage costs?

Denote the initial investment in Project A and Project B by IA and IB, respectively. (i) The cost of raw materials. (ii) The cost of insuring raw materials. (iii) The cost of renting warehouse space.

The expected future cash flows for Project B are exactly the same as for Project A, but are delayed by two years. Hence: NPVA  NPVB



IA

 PV (expected future CFs) 1

(1 0.12)2

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

 [  I B  PV (expected future CFs)]

Set NPVA = NPVB = 500,000:  IA



 IB

 PV (expected future CFs)  500,000  (1  0.12) 2

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

(2 marks) ----------------------------------------------------------------------------------------------------------------

PV (expected future CFs)  500,000

Question 5 Which one of the following statements about rights issues in the UK is false?

Subtracting: (a) IA  I B  500,000 (1 0.12) 2  500,000  127,200 ----------------------------------------------------------------------------------------------------------------

continued …

Existing shareholders can buy new shares in the issuing firm in proportion to the number of shares that they already own. Existing shareholders incur a loss of wealth if they let their rights expire unexercised. Existing shareholders can sell some of their rights to a third party. The new shares carry the same voting rights as existing shares. Rights issues need not be underwritten. (2 marks) ----------------------------------------------------------------------------------------------------------------

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

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Question 6

Question 8

A public company’s existing shareholders are the primary investors in which of the following types of security issue?

Firms facing financial distress may pass up the opportunity to invest in positive-NPV projects rather than raise additional equity to finance those projects because:

(i) (ii) (iii) (iv) (a) (b) (c) (d) (e)

Rights issue. Open issue. Public issue. Placing.

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

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

the required return on the firm’s equity is too high. the benefits will have to be shared with the debtholders. the firm’s debt-to-equity ratio is already too high. there is no interest tax shield associated with equity. the shareholders tell them not to invest in those projects. (2 marks)

(2 marks) ----------------------------------------------------------------------------------------------------------------

As the firm is facing financial distress, its debt is no longer risk-free. The shareholders are the sole beneficiaries of the value added by the project when the debt is risk-free. However, when the debt is risky, the value that the project is expected to add has to be shared between the shareholders and debtholders. The shareholders may not be willing to finance the project by themselves in such circumstances. ----------------------------------------------------------------------------------------------------------------

Question 7 Question 9 In a Modigliani and Miller (1958) world, which of the following statements is/are true? A firm issues new shares in order to pay a cash dividend to its existing shareholders. (i) Capital structure is irrelevant. (ii) A firm’s cost of equity increases linearly with its gearing (D/E) ratio. (iii) The value of a firm depends only on its capital investment policy. (a) (b) (c) (d) (e)

According to Miller & Modigliani (1961), which of the following statements is/are true? (i) The firm’s share price is unaffected. (ii) The value of the firm is unaffected. (iii) The firm’s earnings per share are unaffected.

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

(2 marks) ----------------------------------------------------------------------------------------------------------------

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

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

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Page 7 of 19 Question 10

(B1) Part A

A UK company is expecting to have to pay US$1 million to a US supplier in 3 months’ time. Which one of the following could be employed by the UK company’s treasurer to protect most of this amount against exchange-rate fluctuations?

A capital project has an expected life of 5 years. Its cost of capital is 10% per annum.

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

Expected annual data (in £000’s) for the project are as follows: Sale s Raw materials Labour

Buy US dollars in the spot market. Sell US dollars in the spot market. Buy US dollars in the forward market. Sell US dollars in the forward market. None of the above.

1000 250 200

Administrative expenses Capital allowances

200 100

Assume the corporate tax rate is 30%. Ignore inflation. (2 marks) (a)

To hedge a US-dollar liability, use an instrument that is equivalent to a US-dollar asset. ----------------------------------------------------------------------------------------------------------------

Calculate: (i)

the expected annual incremental after-tax cash-flows. (8 marks)

(ii)

END OF QUESTION PAPER

the present value of the stream of incremental after-tax cash flows. (4 marks)

(b)

Now suppose that there are no capital allowances. Instead the figure of £100,000 per annum refers to depreciation of fixed assets. How do your answers to part (a) change, if at all? Explain your answer, with full workings. (8 marks)

(a)

Figures below are in £000’s: Sales

1000 Raw materials Labour Administration Capital allowances

-250 -200 -200 -1001 -7501 250 1

Taxable income

Note how capital allowances reduce the company’s taxable income, and therefore the amount of corporate tax that it has to pay. The company’s tax bill equals 30% of £250,000 = £75,0001. Hence, its after-tax cash flow each year equals: (£1,000,0000.5 - £250,0000.5 - £200,0000.5 - £200,0000.5 ) - £75,0001 = £275,0001. The incremental cash flows form a five-year annuity1. The present value of the stream of incremental cash flows equals: PV

continued …

 275,000  A 5,10%

 275,000 

  1 1  1    1,042,466 0.10  (1  0.10)5  

3

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(B1) Part B (b)

If instead the figure of £100,000 per year refers to annual depreciation, and not capital allowances, then the calculation proceeds along the following lines: Sales

Both Company B and Company C have 10 million shares outstanding and both companies have just reported total earnings after tax of £24 million.

1000 Raw materials Labour Administration

The cost of equity of each company equals 12%.

-250 -200 -200

Company B pays out all of its after-tax earnings as dividends. -650 1 350 1

Taxable income

Company C currently pays out a dividend of £1.60 per share. Analysts expect it to sustain a long-run return on investment (ROI) of 15% per year.

We don’t subtract depreciation as we are calculating taxable income, not profit. Calculate: The company pays 30% of its taxable income of £350,000 as corporate taxes. Hence, its corporate tax bill equals £105,0001.

(a)

Company B’s earnings per share, share price and price-to-earnings ratio. (8 marks)

1

Its after-tax cash flow each year therefore equals £350,000 - £105,000 = £245,000 . Company B’s earnings per share equal: Again the incremental cash flows form a five-year annuity1. eps 

The present value of the incremental cash flows equals: PV  245,000  A5,10%

 245,000 

  1 1 1   0.10  (1  0.10)5 

3

£24,000,000  £2.40 10,000,000

2

Since Company B pays out all of its after-tax earnings each year as dividends 1, the stream of expected future dividends forms a perpetuity.1

928,742.76  ----------------------------------------------------------------------------------------------------------------

The share price equals PV of this stream of expected future dividends per share: P 

£2.40 0.12

2

 £20.00

since the cost of equity capital equals 12%. The (historical) price-to-earnings ratio equals: P £20.00   8.33 eps £2.40

(b)

2

Company C’s earnings per share, share price and price-to-earnings ratio. (8 marks) Company C’s earnings per share equal: eps 

continued …

£24,000,000  £2.40 10,000,000

2

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Page 12 of 19 (B2) Part A

Company C pays out a dividend of £1.60 per share and re-invests £0.80 per share in capital projects.

Shares in Company X pay an annual dividend on the last day of each year. The forecast dividend (in pence) per share for each of the next five years is as follows:

Its plough-back ratio b therefore equals: b 

£0.80 £2.40



1 3

Year 1 12.21

1

1  0.15  0.05 3

P 

Year 4 17.15

Year 5 19.21

The beta of Company X’s shares equals 1.2. Assume the risk-free rate is 1% and the market risk premium is 4%.

1

(a)

Calculate the cost of equity capital for Company X. (4 marks)

Since its dividend per share stream forms a growing perpetuity, Company Y’s share price is given by the Gordon growth formula: £1.60 (1  0.05) 0.12 -0.05

Year 3 15.31

Thereafter, Company X is able to grow its dividend per share indefinitely at 3% per annum.

Since these capital projects are expected to return 15%, the growth rate of Company Y’s earnings per share, dividends per share and share price equals: G  b  (ROI) 

Year 2 13.67

1

The Capital Asset Pricing Model (which may be quoted without proof) implies:

2

 £24.00

RE

 risk  free rate  1%

 (equity beta)  (market risk premium)

 1.2  4%

3

 5.8%

Note that next period’s expected dividend per share appears in the numerator. (b) Company Y’s (historical) price-to-earnings ratio equals:

P eps (c)



£24.00  10 £2.40

2

The present value of the stream of expected future dividends per share in Years 1-5 is:

13.67 15.31 17.15 19.21 12.21     1  0.058 (1  0.058)2 (1  0.058)3 (1  0.058) 4 (1  0.058)5

Deduce the present value of Company C’s growth opportunities. How is this reflected in the company’s share price? (4 marks) The present value (per share) of Company Y’s growth opportunities equals the difference1 between the share prices1 of Company X and Company Y: 2

PVGO 

Calculate the present value of the stream of expected future dividends per share in Years 1-5. (5 marks)

£24.00  £20.00  £4.00

(c)

5

 64.86

Calculate the present value at the end of Year 5 of the stream of expected future dividends per share from Year 6 onwards. State any formulae that you use and any assumptions that you make. (8 marks) The expected dividend (in pence) per share at the end of Year 6 equals:

----------------------------------------------------------------------------------------------------------------

D6

 D5  (1  0.03)  19.21 1.03  19.79 3

The present value at the end of Year 5 of the stream of expected future dividends per share from Year 6 onwards1 is given by the Gordon growth formula 1: D6 R G

continued …

3



19.79 0.058  0.03

 706.79

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Page 14 of 19 (B2) Part B

(d)

Deduce the share price today of Company X.

(a)

What is the small firm in January effect?

(3 marks) The present value today of this stream of expected future cash flows is: 1



(1  R )5 E

D6 R G E



1 (1 0.058)5

(4 marks) (b)

Is the small firm in January effect consistent with market efficiency? Explain your answer. (8 marks)

(c)

What explanations have been offered for the small firm in January effect? Discuss. (8 marks)

(a)

The small firm in January effect refers to the empirical observation1 that small-firm stocks1 appear to exhibit abnormally high returns1 in the month of January1. This seasonal anomaly implies that abnormal profits can be made by short-selling small-firm stocks at the end of the year, and then buying them back in the first few days of trading at the beginning of the following year.

(b)

The small firm in January effect would appear to be inconsistent with the weak form of the Efficient Markets Hypothesis1. If it persisted year after year, investors would presumably take long positions in small-firm stocks in December in anticipation of making abnormal profits when they unwound their positions in these stocks in early January1. This excess demand for these stocks would be expected to drive their prices upwards in December, thus bringing the effect forward in time1. However, this is not what is observed1.

2

 706.79  533.17

Company X’s share price is therefore P0 = 64.86 + 533.17 = 598.03

1

In fact, it is possible that the market is efficient, and either (a) returns have not been adjusted correctly for risk1; or (b) market imperfections such as transactions costs or taxes have not been recognized1. In other words, the market may be inefficient or the asset pricing model used to estimate benchmark returns is failing to adjust for forms of risk other than systematic risk that are captured in the prices of small-firm stocks 1. Less is known about small firms, and their stocks are more thinly traded than are largecapitalisation stocks, so there may be some form of liquidity risk that is not being taken into account1. (c)

Three possible explanations are: (i) tax-loss selling The US tax year ends on 31 st December. Small-firm stocks that have performed badly may be sold at a loss at the end of December in order to offset capital gains1 made on other stocks, and then re-purchased early on in January1. The fact that the effect shows up in countries where the tax year ends at some other point in the year reflects the international composition of investment portfolios 1.

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(ii) window-dressing

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(B3) Part A 1

Small firms tend to be riskier than large stocks . Portfolio managers who have held small stocks in their portfolios during the year in an attempt to capture the benefits of high growth may replace those stocks with large-cap stocks ahead of the year-end as part of a window-dressing strategy1, only to buy back shares in the small-firm stocks in January once their presentations to trustees are behind them1.

Company Y and Company Z each have annual net operating cash flows of £1,000,000 in perpetuity and identical business risks. Company Y has 7 million shares outstanding and no debt. Company Z has 3.5 million shares outstanding, trading at £1.00 each, and debt with a market value of £1.75 million. Its cost of borrowing is 8% per annum. Assume that each company distributes all of its surplus earnings as dividends.

(iii) managerial compensation (a) Managers are typically rewarded for the degree to which their investment portfolios have outperformed an appropriately risk-adjusted benchmark1. They may therefore sell shares in small stocks that have performed well in order to increase their remuneration for the year, and then buy back shares in those stocks early on in January1.

Calculate the share price of Company Y. State any assumptions that you make. (6 marks) Assume a Modigliani & Miller (1958) “perfect world” 1. The market value of Company Y’s equity equals 7,000,000  S B .

---------------------------------------------------------------------------------------------------------------Since Company Y has no debt in its capital structure, the market value of its equity equals the market value of its assets. The market value of Company Z’s equity equals 3,500,000 £1.00 £3,500,000 1 The market value of Company Z’s debt equals £1,750,0001. Thus, the market value ...