BSc.

(Hons) Banking and International Finance Cohort: BBIF/05/FT Year 2

Examinations for 2006 2007/ Semester 2

MODULE: Corporate Finance
MODULE CODE: ACCF2204 Duration: 2 Hours Reading time: 10 Minutes Instructions to Candidates:
1. Number of Questions Set: Four (4) 2. Number of Questions to be Attempted : Three (3) 3. Question1 (Section A) is COMPULSORY. 4. Attempt any other TWO questions from Section B.

This question paper contains 4 questions and 7 pages.

Page 1 of 7
Sops33

SECTION A -COMPULSORY QUESTION 1: (40 MARKS) Part 1.1

1.1.1 Hose plc presently has a capital structure which is 30 per cent debt and 70 percent equity. The cost of debt (i.e borrowings) before taxes is 9 percent and that of equity is 15 percent. The firms future cash flows, after tax but before interest, are expected to be a perpetuity of Rs. 750,000. The tax rate is 30 per cent.

Required: Calculate the weighted average cost of capital and the value of the firm. (3 marks)

1.1.2 The Directors are considering the partial replacement of equity finance with borrowings so that the borrowings make up 60 per cent of the total capital. Director A believes that the cost of equity capital will remain constant at 15 per cent; Director B believes that shareholders will demand a rate of return of 23.7 per cent; Director C believes that shareholders will demand a rate of return of 17 per cent. Following the assumption that the cost of borrowings before income taxes remains at 9 per cent; you are required to calculate the weighted average cost of capital and the value of the firm under each of the directors estimates. (8 marks)

Page 2 of 7
Sops33

Part 1.2
The following information is given below: Firm Output (units) Fixed Costs (Rs.) Variable Cost per unit (Rs.) Interest on borrowed capital (Rs.) Selling Price per unit (Rs.) A 60,000 7,200 0.20 4,000 0.60 B 15,000 14,000 1.50 8,000 5.00 C 100,000 1,500 0.02 Nil 0.10

Required: Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage and interpret the results. (14 marks)

Part 1.3
The probability of a hot summer is 0.2. The probability of a moderately warm summer is 0.6, whereas the probability of a wet and cold summer is 0.2. If a hot summer occurs then the return on shares in the Ice Cream Manufacturing Company will be 30%. If moderately warm, the return will be 15%, and if cold, 2%.

(a) What is the expected return of Ice Cream Manufacturing Company? (3 marks) (b) What is the standard deviation of that return? (5 marks)

Page 3 of 7
Sops33

Part 1.4
The aggregate average risk free rate (rf) and return on the return (rm) for a 3-year period are 10 per cent and 18 per cent respectively. The results for four portfolios during the same period are summarized as follows: Portfolio A B C D Average Return(per cent) 18 18 24 15 Beta 0.90 1.12 1.50 0.95

Required: Using the CAPM, compute the expected return for each portfolio and compare the actual and expected returns. (7 marks)

Page 4 of 7
Sops33

SECTION B -CHOOSE ANY TWO QUESTIONS

QUESTION 2: (30 MARKS) Part 2.1
Highflyer Plc has two possible projects to consider. It cannot do both they are mutually exclusive. The cash flows are:

Points in time (yearly intervals) 0 1 2 3 4 Project A -420,000 150,000 150,000 150,000 150,000 Project B -100,000 75,000 75,000 0 0

Highflyers cost of capital is 12%. Assume unlimited funds. These are the only cash flows associated with the projects.

(a) Calculate the Internal Rate of Return (IRR) for each project. (b) Calculate the Net Present Value (NPV) for each project. (c) Compare and explain the results in (a) and (b) and indicate which project the company should undertake and why. (15 marks)

Part 2.2
Explain and discuss the implications of the Efficient Markets Hypothesis for the financial management of quoted companies. (15 marks)

Page 5 of 7
Sops33

QUESTION 3: (30 MARKS) Part 3.1

Jumbo Ltd is a leading music entertainment company in the country and the stocks of the company are actively traded in the stock exchange. For the year just ended few days back, the company has reported an earnings per share of Rs 10 and has paid a dividend of Rs 4 per share. The company has been following this payout ratio of 40% during last few years. The retained earnings are reinvested in new projects. The equity shareholders expect a minimum

return of 20% from the investments of equity.

Required: Compute the fair value of the stock under each of the following conditions: i. Suppose the company invests all the retained earnings in projects that yield a return of 20%. (4 marks) ii. Suppose the company invests all the retained earnings in projects that yield a return of 20% and hence now decides to decrease the future payout ratio from 40% to 20%. (4 marks) iii. Suppose the company can invest all the retained earnings in projects that yield a return of 30%. Payout ratio remains at 40%. (4 marks) iv. Suppose the company invests all the retained earnings in projects that yield a return of 30% but finds that it may not have adequate project if it retained 60%. Hence the company now decides to increase the future payout ratio from 40% to 50%. (4 marks)

Page 6 of 7
Sops33

v.

Suppose the company can invest all the retained earnings only in project whose return is expected to be 10%. The company decides to increase the future payout ratio to 60%. (4 marks)

Part 3.2
The investment decision of a firm is dependent of its dividend decision

Explain the argument put forward by James Walter and what is the rationale behind his argument? (10 marks)

QUESTION 4: (30 MARKS)

The Managing Director of your firm is thinking aloud about an appropriate gearing level for the company:

The consultants I spoke to yesterday explained that some academic theorists advance the idea that, if your objective is the maximization of shareholder wealth, the debt to equity ratio does not matter. However, they did comment that this conclusion held in a world of no taxes. Even more strangely, these theorists say that in a world with tax, it is best to gear-up a company as high as possible. Now I may not know much about academic theories but I do know that there are limits to the debt level which is desirable. After listening to these consultants, I am more confused than ever.

Required: Write a report for the managing director both outlining the theoretical arguments and explaining the real-world influences on the gearing levels of firms. (30 marks) ***END OF QUESTION PAPER*** Page 7 of 7
Sops33