SINGAPORE INSTITUTE OF MANAGEMENT

FINANCIAL MANAGEMENT

REVISION WORKSHOP 2017

Introduction

This guide has been prepared for the Revision Workshop for the Financial Management module.
The workshop is organised into two sessions and there are three documents to go with it.
Students should have access all three documents when attending the workshop:

Document 1: SIM Revision 2017 (word document) which presents the questions we will cover
over the two days, including those in the mock examination;

Document 2: SIM Revision Session 1, a PowerPoint presentation that presents the solutions to the
mock examination; and

Document 3: SIM Revision Session 2, a PowerPoint presentation that presents the solutions to the
additional questions in Document 1.

Workshop Arrangements

The workshop is organised as follows:

Day 1: Mock examination: During this session, we will go through the mock examination paper.
Students here will be talked through the solutions and key areas of errors in the examination will
also be identified, introduce different takes on the questions, where appropriate, through what
if type of scenarios and the session will include a discussion on essay techniques for a module
like Financial Management.

Day 2: Numerical Type Questions: This session will focus on numerical, Section A, type questions,
endeavouring to cover the key aspects of Financial Management that students typically find
challenging.

Important:

Kindly ensure that you attend the workshop with paper, pens and a calculator.

Student engagement: At all stages of the workshop, students will have the opportunity to and
are encouraged to ask questions during the sessions. The workshops are intended to improve
your understanding so if you are unsure of concepts, techniques or theory, please ask!

We look forward to working with you,

Alpa Dhanani and Patrick Wylie

April 2017

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CONTENTS
Page

Session: SIM 2017 Mock Examination Paper 3

Section A
Capital Structure (C6)
Valuation Techniques and Mergers (C9, C10)
Investment Appraisal (C2)
Foreign Exchange Risk Management (C12)
Capital Asset Pricing Model (C3,8)
Dividend Policy (C7)

Section B
Capital Structure (C6)
Working Capital Management (C 11)

Session: Numerical type Questions 12

Risk and Return (C3)
Capital Asset Pricing Model (C3)
Sources of Finance (C5)
Capital Structure (C6)
Working Capital Management (C 11)

Session: Essay Examples

Note: C1-C13 represents the chapters in which the topic is addressed in the Financial
Management Handbook by L. Fung

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 SESSION: MOCK EXAMINATION

Requirements: Candidates should answer FIVE of the following EIGHT questions: FOUR from
Section A, ONE from Section B. All questions carry equal marks.

SECTION A

1. Bella, a young and successful entrepreneur is setting up a new venture. She is looking to invest
in one of two mutually exclusive capital projects, each with an outlay of 60m. The possible
payoffs from the project (in present value (PV) terms) are presented below for the three different
states that may materialise. Each state of the market has an equal probability of occurrence.

Investment () Payoffs in PV terms ()

State 1 State 2 State 3

1/3 1/3 1/3

Project A 60m 40 80 100

Project B 60m 0 70 120

REQUIRED:

(a) Show that Project A is the safer of the two projects and has the higher net present value.
(5 marks)

(b) The entrepreneur has no financial capital to invest in either of the two projects and
approaches a banker for a loan of 60m. Assuming that the banker believes that Project
A is selected, show that a risk-neutral banker in a competitive lending environment would
ask for a face value of debt (the amount the firm promises to repay) equal to 70m.
(5 marks)

(c) Would the firms manager working on behalf of the existing shareholders be motivated to
invest in Project B after having obtained a loan? Explain, showing the computations you
deem necessary.
(7 marks)
(d) Explain why managers generally prioritise the interests of shareholders over
debtholders.
(3 marks)
(Total: 20 Marks)

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2. Bryn plc, a company with 100 million shares currently priced at 4 per share, is considering
acquiring Aber Ltd, a privately owned family firm that operates in the same industry as itself. The
company anticipates synergistic benefits of at least 5 million per annum from the merger into
the foreseeable future.

The average net dividend yield for the industry is 8% per annum.

Consultants advising Bryn plc have indicated that, in their view, if Aber Ltd. were a quoted
company, the P.E. ratio for the company would not exceed 12x.

The abbreviated financial accounts for Aber Ltd for the year ended 31st December 2016 are
presented below. Bryn plcs consultants have just completed their due diligence investigation of
Aber Ltd and are satisfied by the figures presented below.

Aber Ltd m

Items from Income Statement

Revenue 500

Profit after taxation 6

Dividend 6

Items from the Balance Sheet

Non-Current Assets 210

Less Current Liabilities (150)

60

Less Non-Current Liabilities -

60

Ordinary Share Capital (1 shares) 150

Share Premium -

Retained Earnings (90)

60

The required rate of return for plcs in the same risk class as Bryn plc is 10%.

REQUIRED:

(a) Calculate the value of Aber Ltd using each of the three approaches listed below:
(i) Net asset value
(ii) Dividend yield model
(iii) Price earnings method
(7 Marks)

(b) For the management at Bryn plc, briefly discuss the relative merits and drawbacks of
ONE valuation method from part (a).
(4 marks)

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(c) The management team at Bryn plc decides to use the price earnings model to value Aber
Ltd. Assuming that the company plans to make a cash offer, determine the minimum and
maximum prices that it should offer for the purchase of Aber Ltd.
(4 Marks)

(d) The investment bank advising Bryn plc has been unable to secure the funds required to
purchase Aber Ltd. The management team at Bryn plc has therefore decided to proceed
with a share exchange and have offered the owners of Aber Ltd. a one for five share
exchange. As an owner of Aber Ltd. explain if you would accept the offer. Support your
advice with appropriate computations.
(5 Marks)
(Total: 20 Marks)

What if scenario for Mergers:

Suppose in the question above, you were also asked to

a. Discuss the benefits and limitations of

a cash acquisition; and

a share exchange from the perspective of both acquirers and targets.

b. Explain why the costs of a share exchange are typically higher than those of a cash
acquisition.

3. United Airlines is thinking about beginning a perpetual service between Chicago and Buenos
Aires. In order to enter this market, United must purchase a new aircraft. It is considering the
purchase of either a Boeing 757, which has a passenger capacity of 200 passengers, or a Boeing
747, which has a passenger capacity of 400 passengers. Assume that the aircrafts last forever
without any depreciation. The prices and operating costs of both aircrafts are shown in the
following table:

Boeing 747 Boeing 757

Purchase Price payable on $105m $55m
purchase of aircraft
Annual Operating Cost $20m $15m
Passenger Capacity 400 200

The primary source of uncertainty facing United is the level of demand. First year demand is
known with certainty: 200 round-trip passengers per day. However, demand in subsequent years
in uncertain and has been predicted as follows:

continue at 200 round-trip passengers per day, with a 50% probability of occurrence
or

rise to 400 round-trip passengers per day, with a 50% probability of occurrence.

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Demand in future years is perfectly correlated to that in year 2 and so will continue either at
200 round-trip passengers per day or 400 round-trip passengers per day into the foreseeable
future.

Revenue is regulated to be $50m annually per 200 round-trip passengers per day (or $100m
annually per 400 daily round-trip passengers per day). For simplicity, assume that all cash flows
will arise at the start of the year (thus the aircraft payments and cash flows arising from the sale
of the trips will all materialise at the start of the year concerned).

The appropriate rate of discount for projects of this type at United Airlines is 10%.

REQUIRED:

a.
i. Determine the Net Present Value (NPV) of purchasing the Boeing 747. Recall all cash flows
arise at the start of the year for simplicity.

ii. If the company opts for the Boeing 757, the company has to purchase the first aircraft
immediately to meet immediate demand. It also has to reach a decision on the purchase
of the second aircraft now to cater for the potential rise in demand in future years, though
delivery will be delayed to when it may be required. Payment for this second aircraft will
take place upon delivery, in twelve months time. Assuming that United commits to taking
delivery of the second Boeing 757 next year, determine the NPV associated with
purchasing the Boeing 757s. Recall all cash flows arise at the start of the year for
simplicity.

iii. Based on your computations above, determine the best course of action for United
Airlines.
(8 Marks)

b. Suppose that Boeing, the aircraft supplier offers to waive the requirement that United
commit to the purchase of the second Boeing 757 now and allows the company to reach
its decision in 12 months time. Given that the company needs to select between the two
aircrafts now, revisit your computations in part (aii) and decision in part (aiii) above.
(8 Marks)

c. Briefly discuss the limitations of your computations in parts (a) and (b) above.
(4 Marks)

(Total: 20 Marks)

Investment Appraisal (not in examination paper; consideration from a traditional

investment appraisal aspect)

Solar Products plc has just developed a new product to be called RTC3. The total development
cost amounts to 500,000. The company is now considering whether to put it into production.
The following information is available. Production of RTC3 will require the purchase of new
machinery at a cost of 4,000,000, payable immediately. This machinery is specific to the
production of RCT3 and will be obsolete and valueless when that production ceases. The
machinery has a useful production life of 4 years and a normal production capacity of 30,000
units per annum. The production capacity can be increased to 40,000 units per year for a one-off
modification cost of 500,000. This modification expense is payable at the beginning of the year

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in which the company wants to increase the production capacity and will be treated as an expense
in the profit calculations. Once the modification is made, the production capacity will stay at
40,000 per year. If the demand exceeds capacity, the company will only be able to sell the
products up to the maximum capacity at the price stated below.

The companys policy is to depreciate this type of machinery using the straight-line depreciation
method.

Production costs per unit of RCT3 are estimated as follows:

Materials 18.00
Labour 10.00
Variable overheads 32.00

Fixed costs, inclusive of depreciation, to run the plant have been estimated at 1,200,000 per
annum. The selling price of RCT3 will be 140 per unit. Demand is expected to fluctuate and a
market survey, which was commissioned prior to the production, has the following findings.

Good Average Bad

Probability 25% 50% 25%
Year 1 30,000 26,000 22,000
Year 2 32,000 30,000 28,000
Year 3 35,000 30,000 25,000
Year 4 40,000 30,000 20,000

Demand in any one year will be independent of demand in prior years.

The companys effective tax rate is 30% and the capital allowances are at 25% of the written down
value of the machinery at the beginning of each year. Any unrelieved capital allowance will be
given in full in the year of disposal. Tax is payable in the same year to which it is related. To keep
things simple assume the new cash flow per year is treated as the taxable profit before capital
allowance. The after-tax cost of capital for the company is 15%.

REQUIRED:

a) For the benefit of management compute the NPV of the project above, assuming the
modification process (i) is not undertaken; and (ii) is undertaken to cater for the extra
demand than the original capacity of the equipment.

b) Based on your computations in part (a), determine whether management should

proceed with the project above and whether it should proceed with the modification
process.

c) Briefly discuss the relative merits of the Net Present Value model against the Internal Rate
of Return model of investment appraisal.

Notes: ignore inflation and assume that all cash flows take place at the end of the year unless
otherwise stated.

4. Coloron plc is a UK based company that specialises in chemical products. It has just agreed to
purchase 100,000 tonnes of chemical SMS from a US based company for a price of US$10 million.
Delivery of the chemical will take place in 30 days time and the supplier has granted Coloron plc

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a credit period of 60 days. As a consequence of Brexit, management at Coloron plc has agreed to
hedge all its foreign transactions and the finance team has gathered the following information
relating to the foreign exchange markets:

(i) The 60 day forward rate is $1.2589 per 1.

(ii) The exercise prices of an over-the-counter option contract with a 60 day maturity is
$1.2780. The premium on the contract is 1 pence per $1.

(iii) At present the interest rates for 60 days are 0.8% and 1.2% in the UK and the US,
respectively. The company will have to pay a 0.1% administration charge on the
dollar value to the bank.

The current spot rate is $1.2488 per 1. The actual spot rate in 60 days time materialises to be
$1.2678 per 1.

REQUIRED:

(a) Determine the values of the transaction under each of the three hedging strategies that
Coloron plc has access to and identify the optimal strategy. (12 marks)

(b) Comparing your outcomes in (a) with an unhedged position, calculate the hedge gain / loss
under each of the three options above.
(3 marks)
(c) Describe the relative merits and limitations of option contracts over forward contracts.

(5 marks)

(TOTAL: 20 Marks)

What if scenario

Suppose in the question above, Coloron plc was selling goods worth $10 million to a US based
customer. Re-work the question using the same information as presented above.

This part of the question will not be covered in class but a separate solution will be posted on
your intranet site.

5. Argon Ltd is considering an investment project with an investment of 100,000, payable

immediately. The net cash flow of the project is expected to be 10,000 per year, commencing at
the end of year one. The cash flow is expected to continue into perpetuity and has an expected
growth rate of 1% per annum. The assets of the project have an unknown beta, but they are very
similar to the assets of Norga plc which has a stock market listing. This company is financed by a
combination of debt (50%) and equity (50%), and the equity has a beta of 1.2. The expected
return on the market index is 12% and the risk free rate is 2%. Assume that the debt is treated
as risk-free and there is no taxation.

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REQUIRED:

(a) Determine the net present value of the potential project at Argon Ltd assuming a beta
value of 1.
(4 marks)

(b) Re-engage in your computations in (a) above, drawing on data about Norga plc.
(5 marks)
(c) It has just become apparent that Norga plc also owns valuable growth opportunities
(these are new projects which have not yet been invested in the assets of these projects
will therefore not be visible on the current balance sheet), alongside assets similar to
those at Argon Ltd. You estimate that 20% of the current value of Norga plc consists of
growth opportunities with a beta of 1, and the remaining 80% consists of assets similar
to the assets in the investment project at Argon Ltd. Re-engage in your computations in
(b) above.
(7 marks)

(d) Briefly explain two limitations of the Capital Asset Pricing Model (CAPM) to appraise
investment projects.
(3 Marks)

(Total: 20 Marks)

Cost of Capital and Gordons Dividend Growth model (not in examination paper;
consideration of a different aspect)

Eagle plc operates in the tourism industry. It too is an all equity company. It plans to pay
dividends of 10m next year. Dividends are expected to grow at a rate of 4% per year
forever. The current market value of Eagle plc is 100m. The risk free rate of interest and
the expected return on the market portfolio are currently 3% and 13% respectively.

Required:

(a) Estimate the equity beta of Eagle plc?

(b) Discuss the strengths and drawbacks of Gordons Dividend model and the Capital
Asset Pricing Model to calculate the cost of equity of companies.

Notes: Ignore taxation and assume that the Capital Asset Pricing Model is in equilibrium.

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6. Omega plc is in the process of determining its dividend policy for the next four years. Two
different proposition have been made to the senior management team: (i) a residual policy, which
the company currently follows and (ii) a fixed dividend arrangement with a growth element.

Below are the details relating to the companys forecast profit levels (based on current assets)
and plans for reinvestment.

0 1 2 3 4
millions
Net profit 120 120 140 140 160
Plans for reinvestment 60 60 80 60 60

Year 0 refers to the first period for which the dividend strategy will be operational and it covers
the last financial year, for which profits have just been reported. Return on the investment levels
above are expected to be 10% per annum for each of the four years.

With the first dividend arrangement, the residual policy, annual dividend payments will be made
from the residual income left after all funds required for reinvestment have been taken from the
profits earned. At the end of year 4, the forecast PE ratio (ex div) under this strategy is expected
to be 14 times.

The second dividend strategy has been proposed by the finance director requires the company to
increase its dividends by a fixed percentage of 5% annually, regardless of the profit level. The
starting dividend payment for Year 0 has been proposed at 60 million. Any earnings not
distributed by the firm as a dividend payment will be retained. These retained earnings will not
earn a return. These funds can be drawn upon to make up for any shortfall in reinvestment that
may arise in future years. It is not known what the PE ratio, ex div, for his strategy will be in year
4, the end of the time period under consideration.

Shareholders in Omega plc require a return of 10% on their investment. Ignore taxation.

REQUIRED:

a. Given the information above and assuming that all the forecasts above come true,
calculate the present value of the companys equity capital under the residual dividend
policy.
(5 Marks)

b. Determine the minimum PE ratio that the company should anticipate under the second
proposed policy, the fixed dividend payment with a growth facility.
(8 Marks)

c. Discuss whether and why you believe the PE ratio in (b) above can be higher than that
associated with the residual dividend policy.
(3 Marks)

d. Briefly explain two other factors that you would encourage the company to consider
before finalising its dividend policy. (4 Marks)
(Total 20 Marks)

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 SECTION B
Answer ONE question from this section.

7. Critically evaluate the Capital Structure Irrelevance Theory originally proposed by

Modigliani and Miller.

(Total: 20 Marks)

8. Describe what working capital refers to and the different compotents of working capital?
Discuss the different factors and strategies that a compny may consider to optimise its
working capital levels.

(Total: 20 Marks)

Writing Essays: Some thoughts

Thought 1: Answer the question.

This may seem obvious but a large proportion of students fail to answer the question set and simply
write about the subject area that the essay is framed round. To an examiner, one way to distinguish
between a students understanding of a topic or their lack of understanding is by assessing are they
answering the question set. If a student presents a good answer that answers the question set, it
signals that (s)he understands the topic well and was therefore able to tease out the relevant points
from the total material about a topic. If an essay simply talks about and around the topic set and
effectively leaves the examiner to decipher what from their answer is relevant to the question set, it
signals the student lacks a good understanding of the material and was therefore unable to pick out
the relevant and salient points him/herself.

Thought 2: Plan your essay.

In one or two minutes, jot down in very brief terms the points you would like to include in your essay.
This serves several points:
Puts forward the relevant points so when you start writing you dont have to repeatedly think of what
you need to include: your guidance is there;
by referring to the question frequently when jotting down these points, it allows you to assess whether
each point you intend to include is actually answering the question set; and finally, it can help you
present a well structured essay (details below) once you have jotted down the points you want to
include, you can number them in the order in which you intend to include them to ensure that you
have a logical and sensible theme running through your essay.

Thought 3: Structure your essay.

The structure of your essay is almost as important as the content (in answering the question) because
it is again an indicator of ones understanding of a topic. If one presents material in a disorderly
fashion, for example talking about the limitations of a model, then introducing it / describing it, you
do not become convinced of his/her ability. Or similarly, if you present some benefits of a model, talk
about its limitations and then return to more benefits the material appears all over the place. The
structure of an essay can make a difference of one classification of degree: achieving a 2:1 instead of a
first, a 2:2 instead of a 2:1 etc.

Thought 4: Essay Length

Is there a specific length of an essay? The simple answer is it is not about quantity but quality. What
you include and how you put your arguments forward are what matters. This said, in order to do so,
you need to have some length to your essay i.e. the quantity needs to be there too. My general advice
would be: write what you can in the time available, ensuring that the content of your essay meets rules
1 3 above.

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SESSION TWO: NUMERICAL TYPE QUESTIONS

Risk and Return

1. Inga is an investor. She has held investments in Security X and in Security Y in the
proportions 50% and 50%, for the last four years.

Details of the performance of the two securities during this period are presented below:

Year Security X Returns % Security Y Returns %

1 10 16
2 12 14
3 14 12
4 16 10

Required:
a. Calculate the average annual return that Inga has earned on her two security
portfolio to date.

b. Calculate the risk of Ingas portfolio and compare it to the individual risks of
Securities X and Y. Based on the information above, the correlation coefficient
between Securities X and Y is -1.

c. Supposed you were not provided with the correlation coefficient in the case above.
How would you calculate it?

What if scenario.

Clara is looking at the following two securities to construct her portfolio

Return (%) Risk (%)
Security P 12 8
Security Q 15 10

The correlation coefficient between the two securities is 0.5.

Required:

a. Determine the proportions of investment Clara needs to make in Securities P and

Q to generate a return of 13.8%.

b. Determine the risk of the portfolio you have created in a.

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2. An investor, Petra, has invested 24,000 into six securities, details of which follow.

Security Standard Correlation coefficient of Actual Returns

deviation returns with market portfolio (%)
Z 0.6 0.2 8
Y 0.28 0.6 11.5
X 0.23 0.9 12.35
W 0.68 0.38 13.5
V 0.4 0.7 17
U 0.44 0.7 17

The risk free rate of interest and the return on the market portfolio have been estimated
at 2% and 12%, respectively. In addition, the standard deviation of the returns on the
market portfolio is 20%.

a. Discuss the basis of systematic risk and why it is considered to drive expected returns
of securities.

b. Calculate the betas and expected returns of the securities above.

c. Identify which of the securities are mispriced and what investment advice you would
offer Petra.

d. Explain the effect of the actions you suggest in (c) on the securities prices.

e. Discuss two potential limitations that may prevent a small investor like Petra from
exercising the advice you offer her in c. above.

Not worth the transaction costs.

Small investor, may not be able to.

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Capital Asset Pricing Model (Risk and Return and Cost of Capital)

Huji plc is a camera manufacturing and retailing company with two primary businesses: a
manufacturing unit that makes the cameras and retail business that distributes and sells cameras,
in the proportions 60% and 40%, respectively. The company believes that its debt and equity
betas are 0.3 and 1.4, respectively and that its asset beta for the manufacturing business is 0.9.
The market value of its debt is 300 million and its 500 million 1 ordinary shares are currently
prices at 1.40 per share.

The company is looking to expand, and two propositions have been put forward, each entailing
an investment of 250 million:

To invest the monies in the two existing businesses at Huji plc, in the proportions that they each
currently represent; or

To diversify the activities of Huji plc and invest 250m in a third industry: photography service.
The asset beta for this industry is 1.32.

The return on the market portfolio and the risk free rate of interest are 14% and 4%, respectively.

Required:
a.
i. Calculate the costs of equity and debt and the overall cost of capital at Huji plc prior to any
expansion / restructuring plans.

ii. Calculate the returns required for each of the two existing divisions at Huji plc prior to
any expansion / restructuring plans.

b. Determine the effect of each of the expansion / restructuring plans on the overall cost of
capital at Huji plc.

c. New camera Ltd. is an unlisted company that also manufactures cameras. Its debt: equity
split has been estimated at 40:60 and the companys debt beta is 0.3, the same as that at
Huji plc.
Determine the overall cost of capital and the cost of equity at New Camera Ltd.

d. Suppose New Camera Ltd changes its debt to equity profile to mimic that at Huji plc.
Explain the effect of this on the overall cost of capital and the cost of equity at New Camera
plc. You are not expected to undertake any computations.

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Sources of Capital

Browns Darling plc is a public company listed on a recognised stock exchange. The company is
financed solely by equity capital. As at today (31 March 2015) the company has 400 million
ordinary 1 shares in issues with a market price of 5.00 / share. Profit before interest and
taxation for the year ended today (31 March 2015) was 200 million. This is expected to increase
by 20% for the year to 31 March 2016 and at a rate of 10% per annum for the next three years.
The forecast growth is a result of a major expansion plan into new markets, financing details of
which are presented below. Profits are not expected to decline after 31 March 2019, though the
growth rate is hard to predict.

In order to finance its expansion plans, the company needs to raise 240 million. Directors of
Browns Darling are considering two alternative methods of funding:

making a one-for-four rights issue of ordinary 1 shares at 2.40 per share; or

issuing 6% loan stock notes at a value of 240 million with 15 year maturity
period.

If the first option is chosen, the existing PE ratio is expected to remain unchanged over the next 4
years. If the second option is chosen the PE ratio is expected to fall to 10.5 times after the issue
and remain the same for the four year horizon.

The rate of corporation tax is 20%.

Required:
(a) Assuming the rights issue is made and fully taken up, calculate:
i. the theoretical ex-rights price of an ordinary share in Browns Darling, and
ii. the value of the rights for each original share.

(b) Calculate the share price in (i) one years time and (ii) in four years time under each of the
two funding options;

(c) Kola owns 4,000 shares in Browns Darling plc. Compare and comment on his current
investment position to his investment position in one years time under each of the two
funding options. Assume that he finances his rights offer with a bank loan.

(d) Comment on and explain your results in parts (a) and (b) above, and the differences
`between the two financing options.

15
Capital Structure
Key points

1. Mossie plc and Aphids plc

Mossie plc and Aphids plc are two companies that operate in the entertainment industry, namely
radio programmes. Both companies undertake similar activities and experience the same risk.
While Mossie plc is an all equity company, Aphids plc is financed by a combination of debt and
equity. Details of their financial structure and cash flow situations follow.

Aphids plc has 200 million shares with nominal and current market values of 1.00 and 2.50 (ex
div.) respectively. The company also has 6% irredeemable debt of 400 million, currently valued
at par. Mossie plc on the other hand, has 400 million shares, valued at 2.50 (ex div.) each; these
shares were issued at a nominal value of 0.50.

Both companies generate a net cash flow per annum of 100 million, which is expected to
continue into the foreseeable future. All cash flows are distributed to shareholders as annual
dividends.

Trevi owns100,000 shares in Mossie plc. She likes her current investment because it generates a
regular income for her. She is also happy to accept the risk that this investment generates for her.
Trevi has, however, been told by a friend that she could generate a better return by changing her
investment from Mossie plc to Aphids plc for the same level of risk.

Required:

(a) Separately calculate the cost of debt and equity and the weighted average cost of capital
of Aphids plc and Mossie plc. Comment on your results.

(b) Calculate Trevis current financial position and show whether, and if so by how, she can
improve this financial position by moving her investment from Mossie plc to Aphids plc
without changing the risk class of her total holding.

(c) Assume that several investors from Mossie plc have taken action like that you suggested
for Trevi. Now also assume that the price of debt and equity at Aphids plc are in
equilibrium. Calculate the equilibrium share price in Mossie and comment on it.

(d) Now assume that you have just been informed that from tomorrow there will be instituted
a corporation tax of 30% on company profits. You are also informed that Aphids
equilibrium value will be unchanged after the introduction. Show the implications of this
on Mossies share price and provide a recommendation for Trevi.

(e) Very briefly, list at least six assumptions that ensure Modigliani and Millers propositions
concerning the valuation of companies cannot hold in the real world.

Notes:
i. For parts (a c) ignore taxation.
ii. Assume that investors can borrow at the same rate as companies or can invest in similar
risk free investments to earn the same rate of return.

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2. Butterfly plc

Butterfly plc is financed by a combination of debt and equity. The company has 110m of debt at
present; this is maturing at the end of the financial year. The company has an opportunity to
invest in a risk free investment opportunity with a cash outlay of 10 million for a certain cash
flow of 20 million at the end of the financial year. The capital for this investment will come from
the companys equity holders. The firm also has in place other assets that generate some cash
flows. The level of these latter cash flows is dependent upon the state of the economy, of which
three possible states: S1, S2 and S3.

The table below details the cash flow positions of the company associated with the three possible
economic states together with their respective probabilities of occurrence.

S1 S2 S3
Probability of occurrence 0.25 0.5 0.25
Cash flow from assets 50 80 120
already in place (m)

REQUIRED:
Assuming that the firm operates purely in the interests of equityholders, determine whether it
should proceed with the project and briefly comment on the underinvestment problem for firms
in the context of capital structure decisions and agency problems between debt- and equity
holders.

Extra question to attempt in your own time. Solution is presented in PowerPoint

presentation.

3. Brayshaw plc
Brayshaw plc operates in the retail industry. The company currently has an issued share capital
of 24 million 1 shares currently priced at 2.50 each and a 6% debt capital of 12 million. Both
the companys equity and debt are priced at equilibrium.

The companys current operating income is 8.64 million, which is expected to continue at this
level into the foreseeable future. The current payout ratio at Brayshaw plc is 100% and this policy
is expected to continue into the future.

The new finance director at Brayshaw plc is very cautious and believes that the company should
be de-geared to reduce its risk given the current risk levels inherent in the retail industry. He has
recommended that the company raise new equity capital through a rights issue of one for three
at a discounted price of 1.50 per share with which to repay the debt capital.

Samuels is an investor in Brayshaw plc and currently owns 144,000 shares. He has read about
the finance directors proposition in the press and is worried about its implications for the value
of his shares and the dividend income that he receives from the company.

REQUIRED:

(a) Calculate the cost of equity and weighted average cost of capital in Brayshaw plc prior to
the changes in its capital structure.

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(b) Based on the Modigliani and Miller (M and M) theory, estimate the equilibrium price of a
share in Brayshaw plc immediately after the restructuring on the assumption that the
restructuring is successful.

(c) Using appropriate computations, demonstrate how Samuels can maintain the financial
position he has at present (pre-structure) in the post-restructure period. You may assume
that investors can borrow at the same rate of interest as companies and that Samuels
intends to maintain his level of risk.

Note: ignore taxation and assume other perfect capital market conditions.

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Financial Planning and Working capital Management

Orian plc reviews its credit policy at regular intervals. Its current policy offers customers a 6 days
credit period with a discount of 2% for all payments settled within 20 days. 20% of its customers
take advantage of the discounting facility and the remainder pay on average in 70 days. Bad debts
currently stand at 4% of annual sales. Sales forecast for next year is 900,000 assuming this credit
policy is maintained.

The new policy proposals are as follows:

Proposal 1
The finance director has called for a review of the policy with the aim to tighten it. She believes
customers should be offered a discount of 2% on pay settlement within 10 days and the
remainder should be offered a credit period of 30 days. 15% of customers are expected to take
advantage of the discounting facility and the remainder of customers will pay on average in 45
days also reduce the pay. Bad debt will fall to 3% and annual sales forecast is not expected to
change under this policy. However, tightening of the policy which will cost the company 38,000
to implement.

Proposal 2
The marketing director has proposed an opposing view calling for relaxing the credit policy to
attract more custom. He proposes that customers be offered a 75 day credit period with a 2%
discount for all payments settled within a 30 days. 25% of customers are likely to take advantage
of the discounting facility and the remainder will pay on average in 90 days. This proposal is
expected to increase annual sales by 25% as the policy will be permissible to high risk customers.
Bad debts will increase to 5% of annual sales.

Orian plc earns a contribution of 20% on sales revenue and its cost of capital has been estimated
at 10%.

Required:

a. Advise Orian plc, which of the two plans, if either to adopt.

b. Discuss strategies other than discounting that may be employed to influence debtor
payments.

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Option Pricing: Binomial Model

Frank is considering investing in options in Honey plc. The current market price of shares in
Honey plc is 600 pence. It is expected that in four months the share price will either rise to 900
pence or fall to 400 pence.

The risk free rate of return (annualised) is 0.5% (i.e. 0.167% for 4 months).

Frank wishes to set up a risk free hedged position by buying shares in Honey plc and selling call
options on shares in Honey plc with time to expiry of 4 months and an exercise price of 700 pence.

REQUIRED:

(a) Show the hedged position you would advise Frank to adopt and calculate the fair price of
the call options.

(b) Assume that call options on shares in Honey plc are currently priced at 95 pence. Advise
Frank on an appropriate investment strategy to adopt. Support your advice with
appropriate calculations.

(c) Assume that call options on shares in Honey plc are currently priced at 70 pence. Advise
Frank on an appropriate investment strategy to adopt. Support your advice with
appropriate calculations.

(d) Explain the effect on the value of the options of:

i. a decrease in the risk free rate of interest;

ii. a decrease in the volatility of shares in Honey plc.

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Essays: Practice Questions

Sources of Long term Finance

Arrat Ltd, is a large privately owned company. The company directors have been very successful
in a short period of time and have a series of very profitable ventures under their belt. The key
constraint they face at present is the inability to raise large sums of long term capital that they
require to initiate these ventures.

For the benefit of the directors at Arrat Ltd. describe the two key forms of long term finance that
the firm may be in a position to raise and identify the benefits and drawbacks of each.

Answer both parts of the question

a. Explain the motivations behind cross-listings by large listed companies

b. If a company decides to undertake a rights issue to raise new equity, discuss the wealth
implications of an existing investor who does not intend to participate in the rights issue
but has the option to sell her right.

Mergers and Acquisitions

Critically evaluate the different motivations underlying mergers and acquisitions

Discuss the different motivations underlying mergers and acquisitions and the factors that are
deemed to contribute to merger failure.

Dividend Policy
Approximately 25% of companies in the US do not make cash dividend payments.
In the light of the statement above, discuss the role of dividend payments for companies and explain
why the dividend landscape covers a large proportion of companies that do pay dividends but also a
sizeable proportion that dont.

CAPM
Discuss the basis of the CAPM and discuss the extent to which empirical evidence is supportive of the
model.

Valuation models
Describe and critically evaluate three methods with which a company may be evaluated.

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Efficient Market Hypothesis
Describe the basis of the EMH and its different forms and discuss the implications of market efficiency
from the perspective of investors.

Describe the basis of the EMH and its different forms and discuss the implications of market efficiency
from the perspective of corporate managers.

Working Capital Management

Describe and evaluate the different mechanisms with which companies may influence their levels of
working capital, and discuss factors that you deem important to influence these strategies.

Ratio Analysis
While ratio analysis is one of the principal mechanisms with which small investors may evaluate
corporate performance, it is not without problems. Anonymous

Discuss the statement above with reference to ratio analysis.

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