seminar5materials / P4AFM-SQB_PDF_j08 / P4AFM-SQB-Qs_j08

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 1 PRIVATE V PUBLIC SECTOR OBJECTIVES

Assume that you are a financial manager in a state owned enterprise that is about to have its majority ownership transferred from the government to the private sector and to become a listed company on the Stock Exchange.

Required:

Discuss the differences in financial objectives that you are likely to face and the changes in emphasis that are likely to occur in your strategic and operational decisions as a finance manager.

(10 marks)

Question 2 AGENCY RELATIONSHIPS

Explain the term “agency relationships” and discuss the conflicts that might exist in the relationship between:

(a)shareholders and managers

(b)shareholders and creditors.

What steps might be taken to overcome these conflicts?

(13 marks)

Question 3 STOCK MARKET EFFICIENCY

The following statement contains several errors with reference to the three levels of market efficiency.

“According to the efficient market hypothesis all share prices are correct at all times. This is achieved by prices moving randomly when new information is publicly announced. New information from published accounts is the only determinant of the random movements in share price.

Fundamental and technical analysis of the stock market serves no function in making the market efficient and cannot predict future share prices. Corporate financial managers are also unable to predict future share prices.”

Required:

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 4 COST OF CAPITAL

(a)Calculate the current pre-tax cost of the following loans.

(i)A 10% coupon rate irredeemable debenture issued at par.

(ii)A 10% irredeemable debenture trading at £85 per cent.

(iii)A 10% redeemable debenture trading at £74 per cent with three years to go to redemption at par.

(iv)A 10% redeemable debenture trading at par, with three years to go to redemption at par.

(v)A 5% irredeemable £1 preference share trading at 65p.

(4 marks)

(b)Calculate the current post-tax cost with a corporation tax rate of 35% of the loans in (a)

(c)Given the following data about share price, compute the cost of equity in each case.

(i)Market price per share £1.50 ex-dividend. Dividend just paid 7.5p, which is expected to remain constant.

(ii)Market price per share £1.65 cum-dividend. Dividend about to be paid 15p, which is expected to remain constant.

(iii)Market price per share £1.20 ex-dividend. Dividend just paid 24p, with expected annual growth rate of 5%.

(iv)Market capitalisation of equity £10 million. Dividends just paid £1.5 million, which are expected to remain constant.

(4 marks)

(d)Compute the market price of the following equities.

(i)W has 50,000 £1 ordinary shares in issue, current dividends 10p each expected to remain constant; cost of equity 10%.

(ii)X has 1,000 £1 ordinary shares in issue, total dividend £500, no growth expected; cost of equity 15%.

(iii)Y has 1 million ordinary shares, the dividend just paid was 10p and it is expected to grow at 5% per annum; cost of equity 15%.

(iv)Z has 10,000 shares in issue, dividends for the next five years are expected to be constant at 10p per share and then grow at 5% per annum to perpetuity; cost of equity 15%.

(4 marks)

(15 marks)

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 5 KELLY PLC

On 1 July 19X5 Kelly plc had the following three classes of debenture, all of which had been in issue for some years.

All the company’s debentures will be redeemed at par. Market evidence suggests that the 6% 19X10 debentures should have a six-monthly gross redemption yield (i.e. internal rate of return to maturity) of 6%. The prevailing level of market interest rates can be assumed to remain unchanged over the next six years.

Required:

(a)Calculate the six-monthly gross redemption yield of the 14% 19X9 debenture. (3 marks)

(b)Determine when investors are likely to assume that Kelly plc will redeem the 14%

19X8–19X10 debentures, and hence calculate their effective annual gross redemption yield. (4 marks)

(c)Estimate the price on 1 July 19X5 that an investor should be prepared to pay for the 6%

(d)Discuss the factors that will influence the market price of issued corporate debentures.

(8 marks)

Ignore taxation in parts (a), (b) and (c), but not (d).

(20 marks)

Question 6 REDSKINS PLC

Redskins plc is a holding company owning shares in various subsidiary companies. Its directors are currently considering several projects to increase the range of the business activities undertaken by Redskins plc and its subsidiaries. The directors would like to use discounted cash flow techniques in their evaluation of these projects but as yet no weighted average cost of capital has been calculated.

Redskins plc has an authorised share capital of 10 million 25p ordinary shares, of which 8 million have been issued. The current ex-dividend market price per ordinary share is £1.10. A dividend of 10p per share has been paid recently. The company’s project analyst has calculated that 18% is the most appropriate after-tax cost of equity capital. Extracts from the latest Statements of Financial Position for both the group and the holding company are given below.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

All debt interest is payable annually and all the current year’s payments will be made shortly. The current cum-interest market prices for £100 nominal value stock are £31.60 and £103.26 for the 3% and 9% debentures respectively. Both the 9% debentures and the 6% loan stock are redeemable at par in ten years’ time. The 6% loan stock is not traded on the open market but the analyst estimates that its actual pre-tax cost is 10% per annum. The bank loans bear interest at 2% above base rate (which is currently 11%) and are repayable in six years. The effective corporation tax rate of Redskins plc is 30%.

Required:

(a)Calculate the effective after-tax weighted average cost of capital as required by the

(b)Discuss the problems that are encountered in the estimation of a company’s weighted average cost of capital when

(i)bank overdrafts, and

(ii)convertible loan stock

(c)Outline the fundamental assumptions that are made whenever the weighted average cost of capital of a company is used as the discount rate in net present value calculations.

(6 marks)

Ignore personal taxation.

(20 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 8 HITECH

You have identified two quoted shares which you believe will exhibit negative correlation in their possible returns over the next year, as follows.

Required:

(a)Calculate the expected return, variance and standard deviation of each security.(4 marks)

(b)Is the correlation between the two shares returns likely to be positive or negative?

(1 mark)

(c)You construct a portfolio consisting of 70% by value of Hitech shares and 30% Reddibank shares.

What are the returns of this portfolio for each of the possible states, A, B and C? Calculate the expected return, variance and standard deviation of the portfolio from these figures. (3 marks)

(d) Using a correlation coefficient of –0.84 calculate the mean return, variance and standard deviation when the portfolio contains 0.7 Hitech and 0.3 Reddibank by value. (3 marks)

(11 marks)

Question 9 WEMERE

The managing director of Wemere, a medium-sized private company, wishes to improve the company’s investment decision-making process by using discounted cash flow techniques. He is disappointed to learn that estimates of a company’s cost of capital usually require information on share prices which, for a private company, are not available. His deputy suggests that the cost of equity can be estimated by using data for Folten plc, a similar sized company in the same industry whose shares are listed on the AIM, and he has produced two suggested discount rates for use in Wemere’s future investment appraisal. Both of these estimates are in excess of 17% per year which the managing director believes to be very high, especially as the company has just agreed a fixed rate bank loan at 13% per year to finance a small expansion of existing operations. He has checked the calculations, which are numerically correct, but wonders if there are any errors of principle.

This rate must be adjusted to include inflation at the current level of 6%. The recommended discount rate is 32.4%.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)Crestlee’s marketing director suggests that it is incorrect to use the same discount rate each year for the investment in packaging as the early stages of the investment are more

risky, and should be discounted at a higher rate. Another board member disagrees saying that more distant cash flows are riskier and should be discounted at a higher

Hotalot plc produces domestic electric heaters. The company is considering diversifying into the production of freezers. Data on four listed companies in the freezer industry and for Hotalot are shown below:

The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice and £1 for Glowcold and Hotalot.

Corporate debt may be assumed to be almost risk free, and is available to Hotalot at 0.5% above the Treasury Bill rate which is currently 9% per year. Corporate taxes are payable at a rate of 35%. The market return is estimated to be 16% per year. Hotalot does not expect its financial gearing to change significantly if the company diversifies into the production of freezers.

Required:

(a)The equity beta of Hotalot is 0.95 and the alpha value is 1.5%. Explain the meaning and

(b)Estimate what discount rate Hotalot should use in the appraisal of its proposed

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(c)Corporate debt is often assumed to be risk free. Explain whether this is a realistic

assumption and calculate how important this assumption is likely to be to Hotalot’s estimate of a discount rate in (b) above. (5 marks)

(d)Discuss whether systematic risk is the only risk that Hotalot’s shareholders should be

(25 marks)

Question 12 BASIC DISCOUNTING

(a)What are the present values of the following cash flows at a discount rate of 10%?

(b)What is the present value at a 15% discount rate of £500 per annum receivable for ten years if the first payment is due

(i)in a year’s time

(ii)in two years’ time

(iii)immediately?

(c)What annual income over five years could be purchased for a capital sum of £15,000 if the appropriate interest rate was 5% and the first of the five payments was due

(i)in one year’s time

(ii)in two years’ time

(iii)immediately?

(d)What is the present value of £1,500 per annum due in perpetuity at a 10% discount rate if the first payment is due

(i)in one year’s time

(ii)in five years’ time?

(e)A payment of £500 is due immediately.

How much would you be prepared to pay four years from now if it were possible to defer payment until then and the appropriate discount rate was 20%?

(f)What would be the present market value, ex-interest, of a 8% debenture with a nominal value of £100 due for redemption at par in five years’ time if the current market rate of interest for that category of stock is 10%?

Ignore taxation.

(15 marks)

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