Question 1:
a) An investment of £100,000 is expected to produce an annual net cash flow of £20,130 for each of the next ten years. Calculate the NPV of the investment if the required rate of return is 9 per cent and determine the approximate value of the investment's internal rate of return.
b) The manager responsible for the pension fund of Ruin plc has to present a report to the Board of Directors on the financial position of the fund. He decides to use the position of the typical employee to illustrate the fund's position. There is £30,000 currently held in the fund for each employee.
The typical employee has 15 years to go to retirement and the company's actuary has proposed that the company should anticipate having to fund pension payments over a retirement period of 12 years for the average employee.
The average pension payment per annum is expected to be £11,000 and the rate of return expected on the pension funds investment is expected to be 6 per cent.
The manager needs to determine the constant annual sum that the company needs to put into the pension fund for each of the next 15 years to be able to meet the fund's obligations. Determine this annual sum. (Assume all payments into the fund and all pension payments are made at the end of each year.)
c) You decided ten years ago to accept a plan put forward by a company in which you held shares to reinvest your annual dividends in the company's shares.
The value of your investment in the company at the time was £26,000. Taking into account the reinvestment of your dividend income this has grown to £96,390 today. Determine the rate of return on your investment over this time period.
d) RBM plc is considering the sale of one of its poorly performing division to a group of its managers. RBM has been offered two alternative payments for the division, an upfront payment of £3 million with a payment of £0.5 million after four years or an upfront payment of £1 million and four annual payments of £0.658 million.
The financial advisors of RBM suggests that the cost of funds to evaluate the proposals is eight per cent. Analyse the two payment possibilities and determine which one you would accept as a manager of RBM.
Question 2:
Gart plc owns and manages garden centres. It is a highly profitable company and analyses very carefully possible locations for its centres. As the most profitable locations have now been exploited its management recognises that the rate of return on further investments will tend to be lower than those the company has achieved on its investments in recent years.
But while the rate of return on new investments is falling, it remains above the shareholders' required rate of return. The company has financed its growth from retentions, and will continue to do so for the next few years. It is anticipated that the company's earnings next year will be £40 million, and the company will reinvest 80 per cent of its earnings. The company is expected 5o earn 40 per cent in perpetuity on these investments. The following year the company will again reinvest the same proportion of its earnings, but the rate of return on these investments is expected to fall to 30 per cent.
Three years from now the company is expected to earn a rate of return of 25 per cent on its investments, which will be limited to 60 per cent of earnings. This is the last year that the company is expected to produce rate of return above the required rate of return. By year four the company's investments are expected to earn no more than 15 per cent - the lowest return acceptable to shareholders.
From year four onwards' the company is expected to limit investments to 40 per cent of earnings and to pay out 60 per cent of earnings to shareholders in the form of dividends.
a) Provide an estimate of the value of the company, indicating the proportion of the value accounted for by the company's growth prospects.
b) Determine the prospective price-earnings ratio of the company and comment on its anticipated change in value over the next three years.
Question 3:
The finance director of Ast Ltd is considering an investment in machinery to expand its production. The demand for the company's product has increased over the last few years and it has been necessary to sub-contract some of its production to another manufacturer. Last year Ast Ltd bought 15,000 units at a price per unit of £140 from this supplier. Next year it is anticipated that the demand faced by Ast Ltd will increase by a further 5,000 units, and this will increase the need for subcontracting unless the company's manufacturing capacity is extended.
Demand is not expected to expand further in subsequent years but it is anticipated that it will remain at the higher level for the next five years. It has been established that it would be possible to increase the level of purchases from the sub-contractor on the same terms as agreed for the initial 15,000 units. Ast's management anticipates that the p6roduct will be withdrawn from the market five years from now. It is expected that the final selling price obtained by Ast Ltd for its product will remain constant at £250 per unit over this time period.
The machinery necessary to produce the additional 20,000 units would cost £2 million and would be depreciated for tax purposes on a straight-line basis over a five year life. It is estimated that after five years the machinery would have a resale value of about £120,000.
The machinery would be located in the company's factory along with its existing machinery, and it would account for 10 per cent of the floor space.
There is considerable spare capacity in the factory and it is most unlikely that the company will have any alternative use for this unused capacity over the next five years. The company's production manager has produced the following estimates of costs per unit, but the finance director is not confident of his understanding of financial analysis:
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Labour expenses
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£28
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Raw materials
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40
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Depreciation
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20
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Power etc.
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10
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Costs of space*
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8
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Direct overheads
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12
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General overheads
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12
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Overall costs per unit
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£130
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The company allocates a cost for the space occupied to each activity based on floor space
The added production would require an increase in working capital in the form of stocks, valued at cost, of £300,000. The tax rate is 20 per cent and the required rate of return is 18 per cent.
Determine the net present value of the investment, specifying your key assumptions.
Question 4:
a) i. Determine the expected return and risk of a two asset portfolio made up of 40 per cent of X and 6-0 per cent of Y given the following information
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Expected return
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Risk (Standard Deviation)
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Security X
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16 per cent
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18 per cent
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Security Y
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22 per cent
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30 per cent
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Correlation of X and Y = 0.25
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ii. The return on securities are independent and the average security has an expected return of 14 per cent with a standard deviation of 23 per cent. Determine the expected return and standard deviation of returns for a portfolio of 90 securities.
b) Explain what is meant by naïve diversification and consider some of the lessons to be derived from examining the consequences of increasing the number of randomly chosen securities held in a portfolio.
Question 5:
General Electronics plc's shares have recently been trading around the £5.00 mark over the last few days. This is close to the highest price recorded for the company's shares, and reflects the market's view that the company has considerable potential for profitable growth.
The company has 100 million shares outstanding and overall value of the company's shares is £500 million. The company has relied heavily in the past on retentions to finance its investments but it now finds that some of its growth will have to be funded externally. The market has been anticipating an announcement of an issue of shares.
On this basis the company is to undertake a rights issue to raise £240 million to fund a major investment programme to extend the company's activities in new markets. It is proposed to issue shares at a discount of twenty five per cent, and to have the issue underwritten. The possibility of a deep discount issue with the new shares being offered at £3.00 per share was also considered. However, the company's investment bank advised against this, and recommended an underwritten issue at a discount of 25 per cent and the company has accepted this advice.
a) Specify the terms of the planned issue, determine the theoretical ex-rights price and the expected value of a right.
b) Demonstrate that in principle a shareholder holding 100 shares will be equally well off by subscribing to the shares or by selling her rights.
Question 6:
Prices of Calls and Puts Options the shares of Marks & Spencer
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Share Price
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Exercise Price
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Calls
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Puts
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Sep
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Oct
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Nov
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Sep
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Oct
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Nov
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210
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205
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12.0
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24.0
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27.0
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6.0
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17.5
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19.5
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210
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9.5
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21.5
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24.5
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8.5
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20.0
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22.0
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a) Explain why the November calls are trading at higher prices than the September calls.
b) Draw a diagram illustrating a straddle, using calls and puts expiring in November and an exercise price of 205. Explain the circumstances in which an investor might consider it worthwhile to invest in a straddle.
c) Develop a covered call using the data provided and comment on the nature of the payoffs produced and the potential uses of the strategy.
Question 7:
i. Explain the three different forms of the efficient markets hypothesis.
ii. Discuss some of the implications of efficiency market theory for corporate financial policy.
Question 8:
Following the analysis developed by Modigliani and Miller it is generally accepted that the capital structure of companies have no affect on their market value when capital markets are perfectly competitive.
But financial managers appear to give considerable importance to capital structure. Discuss some of the reasons why managers might be concerned about decisions relating to capital structure.