THE UNIVERSITY OF WARWICK

Examination: Summer 2008

FINANCIAL MANAGEMENT

SPECIMEN SOLUTIONS

Turn Over
IB1140 Page 2 of 15

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SECTION A

Answer ALL of the questions in this section

Each question in this section is worth 2 marks

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A1. You inherit £20,000 and invest it in a bank account that pays 6% interest per annum. You plan
to use the money to support yourself over the coming four years by withdrawing the same
amount of money from the account at the end of each of the four years. What is the maximum
sum of money that you can withdraw annually?

(a) £5,136.91
(b) £5,445.12
(c) £5,771.83
(d) £6,101.88
(e) £6,395.88
(2 marks)

The four equal payments C form a four-year annuity, with present value £20,000. Hence:

C × A 4,6% = 20,000

The annuity factor A4,6% equals:

1  1 
A 4, 6% = × 1 −  = 3.4651
0.06  (1 + 0.06) 4 

Solving for C gives:

20,000
C = = 5771.83
3.4651

If annuity tables are used instead, then A4, 6% = 3.47 and C = 5763.69, so response (c) is
unambiguously the closest.
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A2. The share price of Company A has fallen each week for a number of weeks in succession.
Assuming the share price follows a random walk, what is your best forecast of what the share
price will do over the coming week?

(a) The share price will also fall over the coming week.
(b) The share price will rise over the coming week.
(c) The share price will fall then rise over the coming week.
(d) The share price is equally likely to rise or fall during the coming week.
(e) The share price will not change over the coming week.
(2 marks)

If the share price follows a random walk, then the next change in share price is equally likely to
be up or down.
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A3. In which of the following cases can the NPV and the IRR result in different decisions?

(i) The project cash flows change sign more than once.
(ii) The project has a large initial investment cost.
(iii) The investment decision involves choosing between two mutually-exclusive projects.

(a) (i) only.

(b) (iii) only.
(c) (i) and (ii) only.
(d) (i) and (iii) only.
(e) (i), (ii) and (iii).
(2 marks)

There can be as many values of the IRR as there are changes in the sign of the cash flows. If
there are multiple values of the IRR, none of those values has any economic meaning.

Question 6 in the problem sheet on Project Appraisal is an example of how the IRR can appear
to rank two mutually-exclusive projects differently from the NPV.
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A4. 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?

(a) X and Y agree on which projects should be undertaken only if capital is rationed.
(b) X and Y agree on which projects should be undertaken only if capital is not rationed.
(c) X and Y always agree on which projects should be undertaken, regardless of whether
capital is rationed or not.
(d) X and Y never agree on which projects should be undertaken.
(e) None of the above statements is true.
(2 marks)

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 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.
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A5. The rationale for not including sunk costs in project appraisal is that:

(a) they are usually small in magnitude.

(b) they are recovered at the end of the project.
(c) they are irreversible.
(d) they represent nominal, not real, outflows.
(e) including them reduces the chances of the project being accepted.
(2 marks)

Sunk costs are associated with earlier investment decisions and are therefore irreversible.
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A6. In project appraisal, an increase in net working capital can be modelled as:

(a) a cash inflow at the beginning of the project only.

(b) a cash outflow at the beginning of the project only.
(c) a cash inflow at the beginning and an equal cash outflow at the end of the project.
(d) a cash outflow at the beginning and an equal cash inflow at the end of the project.
(e) a decrease in the initial amount invested.
(2 marks)

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.
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A7. A firm that uses its weighted average cost of capital to evaluate projects, regardless of how risky
those projects are, will tend to:

(a) become less risky over time.

(b) become more risky over time.
(c) accept only low-risk projects.
(d) accept only average-risk projects.
(e) accept only high-risk projects.
(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.

The firm will therefore become more risky over time.

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A8. What is expected to happen to a security that offers a higher risk premium than that predicted by
the Securities Market Line?

(a) Its beta will increase.

(b) Its beta will decrease.
(c) Its price will increase.
(d) Its price will decrease.
(e) Its price will not change.
(2 marks)

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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A9. 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) 1,250 units.

(b) 2,000 units.
(c) 2,400 units.
(d) 4,000 units.
(e) 7,500 units.
(2 marks)

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

The economic order quantity EOQ is given by the formula:

2⋅ N ⋅R 2 × 360,000 × 200
EOQ = = = 16,000,000 = 4,000
C 9

where N = total number of units per year, R = re-ordering costs and C = storage cost per unit.
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A10. If the marginal reduction in re-ordering costs exceeds the marginal increase in storage costs,
then the firm:

(a) has minimised its re-ordering costs.

(b) has minimised its storage costs.
(c) has minimised its total costs.
(d) should increase its order size.
(e) 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.

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.
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A11. A company has 4.8 million shares outstanding at a market price of £9.00 per share. It wants to
raise £6 million via a rights offering. The issue price is to be £7.50 per share. How many shares
must an existing shareholder own in order to qualify for the right to buy one new share?

(a) 1.2
(b) 2.4
(c) 3.6
(d) 4.8
(e) 6.0
IB1140 Page 6 of 15
(2 marks)

The number of new shares to be issued equals:

£6,000,000
= 800,000
£7.50

Therefore, the terms of the rights issues are 1-for-6 at £7.50.

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A12. 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:

(a) the supply of the firm’s equity outstrips the demand for the firm’s equity.
(b) the firm’s managers know that the rights issue is over-priced.
(c) the firm has no positive-NPV investment opportunities.
(d) the firm’s underwriters charge too much.
(e) the stock market is inefficient.
(2 marks)

Although there are always exceptions e.g. the Royal Bank of Scotland’s £12 billion rights issue
in 2008, the stock market generally reacts negatively to the announcement of a rights issue.
This is because the market that the managers of the company know of some bad news that leads
them to want to raise additional capital now, rather than later, and in the form of equity rather
than debt. The suspicion is that the managers believe the share price is likely to fall when
whatever piece of bad news they know leaks out, and therefore decide to hold the rights issue
whilst the share price is relatively high.
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A13. In a Modigliani-Miller (1958) perfect world, as a firm replaces more and more of its equity with
debt, then:

(a) the variability of its earnings per share increases.

(b) its operating risk increases.
(c) the market value of its assets increases.
(d) its weighted average cost of capital increases.
(e) its cost of equity decreases.
(2 marks)

In an MM (1958) perfect world, capital structure is irrelevant. As equity is replaced with debt,
the firm’s cost of equity increases as the diminishing shareholder base continues to shoulder the
same amount of operating risk. Neither the market value nor the weighted average cost of
capital of the firm changes. Operating risk is also fixed since this reflects how risky the firm’s
operations are.
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The following information applies only to Questions A14 and A15.

Assume a Modigliani-Miller (1963) world in which the corporate tax rate is 30%.

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.

A14. What is the value of Ungeared plc?

(a) £1,250,000
(b) £1,500,000
(c) £2,083,333
(d) £2,375,000
(e) £2,458,333
(2 marks)

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.

Since these cash flows form a perpetuity:

250,000
E UnG = = 2,083,333
0.12
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A15. What is the value of Geared plc?

(a) £1,250,000
(b) £1,500,000
(c) £2,083,333
(d) £2,375,000
(e) £2,458,333
(2 marks)

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

Hence, the market value of Geared plc equals:

VGeared = VUngeared + TC ⋅ D = 2,083,333 + 375,000 = 2,458,333

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IB1140 Page 8 of 15
A16. 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:

(a) the required return on the firm’s equity is too high.

(b) the benefits will have to be shared with the debtholders.
(c) the firm’s debt-to-equity ratio is already too high.
(d) there is no interest tax shield associated with equity.
(e) the shareholders tell them not to invest in those projects.
(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.
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A17. Miller and Modigliani’s (1961) dividend irrelevance proposition depends upon:

(a) firms maintaining a constant dividend payout ratio.

(b) dividends being taxed at the same rate as capital gains.
(c) the existence of a dividend tax clientele.
(d) the efficiency of capital markets.
(e) firms not buying back any of their existing shares.
(2 marks)
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The following information applies only to Questions A18 and A19.

A firm is 100% equity-financed. It has 50,000 shares outstanding with a market value of £8.00
per share. Total earnings for the year just ended were £80,000. The firm has cash of £40,000 in
excess of what it needs to fund its positive-NPV projects. It is considering whether to use the
surplus cash to pay a special cash dividend of £40,000 or to buy back £40,000 of its shares.

A18. Assume the firm pays out the excess £40,000 in the form of a cash dividend. What will be the
firm’s earnings per share and price-to-earnings ratio, respectively, once the dividend is paid?

(a) eps = £0.80; PE-ratio = 5.0

(b) eps = £1.60; PE-ratio = 4.5
(c) eps = £1.60; PE-ratio = 5.0
(d) eps = £1.60; PE-ratio = 9.0
(e) eps = £1.60; PE-ratio = 10.0
(2 marks)

The earnings per share eps is given by:

£80,000
eps = = £1.60
50,000

If £40,000 is paid out as dividends, then the share price will fall by the amount of the dividend
per share.
IB1140 Page 9 of 15
£40,000
The dividend per share equals 50,000 = £0.80

Hence, the new share price equals £8.00 - £0.80 = £7.20. The price-to-earnings ratio equals:

P £7.20
PE = = = 4.5
eps £1.60
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A19. Assume now that the firm uses the excess £40,000 cash to buy back some of its outstanding
shares at £8.00 per share. What will be the firm’s earnings per share and price-to-earnings ratio,
respectively, after the share buy-back?

(a) eps = £0.80; PE-ratio = 10.0

(b) eps = £1.60; PE-ratio = 5.0
(c) eps = £1.60; PE-ratio = 4.5
(d) eps = £1.78; PE-ratio = 4.5
(e) eps = £1.78; PE-ratio = 5.0
(2 marks)

The number of shares bought back equals:

£40,000
= 5,000
£8.00

The number of shares outstanding after the share buyback is therefore 45,000.

The earnings per share eps and the price-to-earnings ratio PE, respectively, are given by:

£80,000 P £8.00
eps = = £1.78; PE = = = 4.5
45,000 eps £1.78

Note that the share price remains unchanged at £8.00 in this case.
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A20. Assume the spot exchange rate between UK sterling and the US dollar is £0.5027 per $1.00.
Expected inflation in the UK is 2.2% and expected inflation in the US is 4.3%. Both inflation
rates are annualised rates. What is the expected exchange rate one year from now if relative
purchasing power parity holds?

(a) £0.4926 per $1.00

(b) £0.5027 per $1.00
(c) £0.5130 per $1.00
(d) £0.5138 per $1.00
(e) £0.5243 per $1.00
(2 marks)
IB1140 Page 10 of 15
Since the exchange-rate is quoted in terms of how many UK pounds per US dollar, the quoted
currency is the US dollar.

Relative purchasing-power parity implies:

 1 + i UK 
E[ S £/$ ] = S £/$ ×  
 1 + i US 

where S£/$ is today’s spot exchange rate, E[S£/$] is the expected future spot exchange rate, and iUK
and iUS denote the expected inflation rates in the UK and US, respectively.

Hence:

[
E S £/$ ]  1 + 0.022 
= 0.5027 ×  
 1 + 0.043 
= 0.4926

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END OF SECTION A
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SECTION B

Answer ANY TWO questions in this section

Each question in this section is worth 30 marks

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Question B1

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 (after-tax) cost of capital is 10% and the corporate tax rate is 30%. Ignore inflation.

(a) 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.
(30%)

(b) 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.
(40%)

(c) Would your answer to part (b) change if there were no capital allowances? Explain.
(30%)
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(a) The written-down value of the machine after t years is given by 28,000 × (0.75) t .

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

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

The schedule of capital allowances is as follows:

End of Year
0 1 2 3 4 5
Book value 28,000 21,000 15,750 11,813 8,859. 6645
Capital 7,000 5,250 3,938 2,953 2,215 5,645
allowance
IB1140 Page 12 of 15

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

End of Year
0 1 2 3 4 5
Operating CF 10,000 10,000 10,000 10,000 10,000
Capital allowance -7,000 -5,250 -3,938 -2,953 -2,215 -5,645
Taxable income -7000 4,750 6,062 7,047 7,785 4,355
Corporate tax -2,100 1,425 1,819 2,114 2,336 1,307

The incremental after-tax cash flows and the NPV are calculated as follows:

End of Year
0 1 2 3 4 5
Machine -28,000 1000
Change in WC -8,000 8,000
Operating CF 10,000 10,000 10,000 10,000 10,000
Corporate Tax 2,100 -1,425 -1,819 -2,114 -2,336 -1,307
After-tax CF -33,900 8,575 8,181 7,886 7,664 17,693
PV @ 10% -33,900 7795 6761 5925 5235 10986
NPV @ 10% 2803

The NPV is positive so the company should go ahead and buy the machine today.

(c) The tax cash-flow savings are given by:

End of Year
0 1 2 3 4 5
Capital allowance 7,000 5,250 3,938 2,953 2,215 5,645
Tax CF saving 2100 1575 1181 886 664 1693
PV @ 10% 2100 1432 976 666 454 1051
Sum of PVs 6679

In the absence of capital allowances, the NPV would be 2803 – 6679 = - 3876. Hence, the
company should not go ahead with the project.

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IB1140 Page 13 of 15

Question B2

Company X, which is listed on the stock market, needs to estimate the hurdle rate for projects that will
be undertaken by a new division that it is creating. The new projects will be of comparable risk to the
company’s existing portfolio of capital projects.

Company X has both equity E and debt D in its capital structure, and its target debt-to-equity (D/E)
ratio is 25%. The beta of Company X’s equity is 0.8. Assume that Company X’s debt is risk-free.

The risk-free rate equals 6% and the market risk premium equals 4%. Ignore taxes.

(a) Calculate Company X’s cost of equity capital. (40%)

(b) Calculate Company X’s weighted average cost of capital. (40%)

(c) How would your answer to part (b) change if the projects that the new division will undertake
were riskier than the company’s existing portfolio of capital projects? Explain your answer.
(20%)
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(a) The equation of the Securities Market Line is:

E[ RE ] = Rf + β × (E[ RM ] − Rf )
E

Substitute Rf = 6%, E[RM] – Rf = 4% and β = 0.8 to obtain:

E[ RE ] = 6% + 0.8 × 4% = 9.2%

(b) The weighted average cost of capital WACC is given by:

D E
WACC = × E[ RD ] + × E[ RE ]
D+E D+E

Since the company’s target D/E ratio is 0.25:

D 1 1 E 4 4
= = , = =
D+E 1+ 4 5 D+E 1+ 4 5

The weighted average cost of capital therefore equals:

1 4
WACC = × 6% + × 9.2% = 8.56%
5 5

The cost of debt capital E[RD] = 6%, since the company’s debt is assumed to be risk-free.
IB1140 Page 14 of 15

(c) The value of the WACC calculated in part (b) is the appropriate hurdle rate to use for a project
that is of the same risk as the company’s overall portfolio of capital projects.

If the new project is of higher (lower) risk than the company’s average-risk project, then a
higher (or lower) value of the hurdle rate should be used.

See IB2360 Finance 2 for more details of how to do this!

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IB1140 Page 15 of 15

Question B3

A company forecasts that its earnings next year will be £100 million, and that it will need to raise
external finance of £40 million.

Assume a Miller-Modigliani (1961) perfect world.

(a) What are the key characteristics of a Miller-Modigliani (1961) perfect world?
(20%)

(b) How much does the firm intend to pay out as dividends if it expects to invest £135 million in
capital projects next year? Explain your answer.
(30%)

(c) How much external finance will the company have to raise if it wishes to double the amount
that it pays out in dividends, but still invest £135 million in capital projects next year?
(30%)

(d) Does your answer to part (c) depend on whether the firm raises the external finance in the form
of debt or equity? Explain your answer.
(20%)
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(a) In a Miller-Modigliani (1961) perfect world, there no taxes, no transactions costs and no
information asymmetry. Financial markets are assumed to be perfectly efficient.

(b) Myers’ (1984) pecking-order hypothesis implies that the firm will want to use retained earnings
first and then external capital to finance its planned capital investments. Thus, the forecast
capital investment of £135 million will be funded partly by retained earnings of £100 million
and partly by external finance of £35 million. That will leave £5 million for distribution to
shareholders in the form of dividends.

(c) We assume that the firm’s capital investment policy is fixed. Therefore, the firm still wishes to
invest £135 million in capital projects.

If the company wishes now to double the amount paid out in dividends from £5 million to £10
million, then the amount K (in £000’s) of external financing that it will need to raise is given by:

100 + K = 135 + 10 i.e. K = 45

Hence, the firm will need to raise £45 million from external sources.

(d) In a Miller-Modigliani (1961) world, capital structure is irrelevant.

Therefore it makes no difference whether the firm raises the additional external finance in the
form of equity or debt.

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END OF QUESTION PAPER