BEA3008

UNIVERSITY OF EXETER

BUSINESS SCHOOL

May 2017

FINANCE FOR MANAGERS

Module Convenor: Aurel Kucani

Suggested solutions
 SECTION A

QUESTION A1

Part a - Workings:

Note: rounding errors are allowed. Full marks will be given for the method used and actual
final numbers can be different.

W1 - Accounting for inflation: selling price and variable cost per unit per year

Year Selling price per unit Variable cost per unit

1 14 + (14 x 0.03) = 14.42 4 + (4 x 0.02) = 4.08
2 14.42 + (14.42 x 0.03) = 14.85 4.08 + (4.08 x 0.02) = 4.16
3 14.85 + (14.85 x 0.03) = 15.30 4.16 + (4.16 x 0.02) = 4.24
4 15.30 + (15.30 x 0.03) = 15.76 4.24 + (4.24 x 0.02) = 4.32

(3 marks)

W2 Sales revenue and variable costs for each year

Year Units levels Sales Revenue Variable Costs

1 20,000 20,000 x 14.42 = 288,400 20,000 x 4.08 = 81,600
2 40,000 40,000 x 14.85 = 594,000 40,000 x 4.16 = 166,400
3 10,000 10,000 x 15.30 = 153,000 10,000 x 4.24 = 42,400
4 20,000 20,000 x 15.76 = 315,200 20,000 x 4.32 = 86,400

(2 marks)

W3 - Fixed costs per year

Year Fixed Costs

1 12,000 + (12,000 x 0.05) = 12,600
2 12,600 + (12,600 x 0.05) = 13,230
3 13,230 + (13,230 x 0.05) = 13,892
4 13,892 + (13,892 x 0.05) = 14,587

(2 marks)

W4 Capital allowances on a reducing balance basis

Year Capital Allowances

1 170,000 x 0.25 = 42,500
2 127,500 x 0.25 = 31,875
3 95,625 x 0.25 = 23,906
4 Remaining balance: 95,625 23,906 5,000 (scrap value) = 66,719

(2 marks)

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 W5 - Nominal rate

(1+rnominal) = (1+rreal) (1+rinflation)

rnominal = [(1+0.045) (1+0.04)] 1 = 9%

(2 marks)

Net present value (NPV)

Year 1 Year 2 Year 3 Year 4 Year 5 Marks

Sales Revenue (W2) 288,400 594,000 153,000 315,200

Less: Variable Cost 1 mark
81,600 166,400 42,400 86,400
(W2)
Contribution 206,800 427,600 110,600 288,800 1 mark
Less: Fixed Costs (W3) 12,600 13,230 13,892 14,587
Net Cash Flow 194,200 414,370 96,708 274,213 1 mark
Less: Capital
42,500 31,875 23,906 66,719 1 mark
Allowances
PCTCT* 151,700 382,495 72,802 207,494 1 mark
Less: Tax 45,510 114,749 21,841 62,248 2 marks
After Tax Cash Flow 194,200 368,860 -18,041 252,372 -62,248 1 mark
Asset Disposal 5,000 1 mark
194,200 368,860 -18,041 257,372 -62,248
Discount Factors @ 9% 0.917 0.842 0.772 0.708 0.650 1 mark
Discounted Cash Flow 178,081 310,580 -13,928 182,219 -40,461 1 mark

*Profits Chargeable to Corporation Taxes.

(11 marks)

PV of discounted cash flows: 178,081 + 310,580 13,928 + 182,219 40,461 = 616,491

NPV = 616,491 170,000 = 446,491.

(1 mark)

Note: full marks will be given for the method used and actual final numbers can be different.

Part b

The net present value is positive, hence undertake the project.

(2 marks)

[25 marks in total]

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QUESTION A2

Part a

1.
i) The expected return is calculated as the sum of each return times the probability of that
return occurring.

E( r1 ) = (0.2 x 0.4) + (0.3 x 0.2) + (0.2 x 0.2) + (0.3 x 0.3) = 0.08 + 0.06 + 0.04 + 0.09 =
0.27 or 27%

(1 mark)

E( r2 ) = (0.2 x 0.2) + (0.3 x 0.3) + (0.2 x 0.4) + (0.3 x 0.2) = 0.04 + 0.09 + 0.08 + 0.06 =
0.27 or 27%

(1 mark)

ii) Firstly we calculate the variance. This is the sum of all squared deviations from the
expected return multiplied by their probabilities. The standard deviation is the square root
of the variance.

12 =0.2(0.4 0.27)2 +0.3(0.2 0.27) 2 +0.2(0.2 0.27) 2 +0.3(0.3 0.27) 2 = 0.00338 +

0.00147 + 0.00098 + 0.00027 = 0.0061

1 = (0.0061)1/2 = 0.0781 or 7.81%

(1.5 marks)

22 = 0.2(0.2 0.27)2 +0.3(0.3 0.27) 2 +0.2(0.4 0.27) 2 +0.3(0.2 0.27) 2 = 0.00098 +

0.00027 + 0.00338 + 0.00147 = 0.0061

2 = (0.0061)1/2 = 0.0781 or 7.81%

(1.5 marks)

iii) To find the covariance, we multiply each possible state times the product of each
assets deviation from the mean in that state, and then add them all together.

Cov(1,2) = 0.2(0.4 0.27)(0.2 0.27) + 0.3(0.2 0.27)(0.3 0.27) + 0.2(0.2 0.27)(0.4

0.27) + 0.3(0.3 0.27)(0.2 0.27) = -0.00182 0.00063 0.00182 0.00063 = -0.0049

(2 marks)

iv) The correlation is the covariance divided by the product of the two standard deviations.

1,2 = Cov(1,2) / 1 2 = - 0.0049 / (0.0781)(0.0781) = -0.8

(1 mark)

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v) The expected return of the portfolio is the sum of the weight of each asset times the
expected return of each asset.

E(RP) = w1E(R1) + w2E(R2) = 4/8(0.27) + 4/8(0.27) = 0.135 + 0.135 = 0.27 or 27%

(2 marks)

vi) Firstly we calculate the variance of the portfolio, which can be expressed as:

2P = w 12 12 + w 22 22 + 2w1w2cov(1,2)
2P = 0.502(0.0061) + 0.502(0.0061) + 2(0.50)(0.50)(-0.0049) = 0.0006

The standard deviation of the portfolio is:

P = (0.0006)1/2= 0.024 or 2.4%

(2 marks)

2.
Student responses could vary, but should at least cover:

Covariance examines the degree to which the returns on the two assets vary in
relation to each other.
Covariance can either be positive or negative. Positive (negative) covariability
indicates that the returns on the two assets tend to move in the same (opposite)
direction.
Covariance is important in portfolio theory because the variance of a portfolio is a
combination of individual variances and the covariances among all assets in the
portfolio.
The standardised covariance is correlation (which is defined as the ratio of the
covariance between two random variables and the product of their standard
deviations).
As long as the correlation coefficient between the returns of two securities is below
1, there is a benefit to diversification.
A portfolio with negatively correlated stocks can achieve greater risk reduction than
a portfolio with positively correlated stocks, holding the expected return in each
stock constant.
Applying proper weights on perfectly negatively correlated stocks can reduce
portfolio variance to zero.

(5 marks)

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Part b

Student responses could vary, but should at least cover:

Students can distinguish between unsystematic risk (also called diversifiable,

unique, or idiosyncratic risk) and systematic risk (also called market, non-
diversifiable risk).
Under the CAPM, beta measures the systematic risk of an individual security or
portfolio.
The formula for beta.
The market has a beta of 1, and risk-free asset has a beta of 0.
The beta of a portfolio is the weighted average of the betas of each security
contained in the portfolio. Hence, by adding securities with betas that are higher
(lower), the systematic risk of the portfolio can be increased (decreased) as
desired. Portfolios with betas greater (lower) than 1 have systematic risk higher
(lower) than that of the market.
CAPM formula. The security market line (SML) is the graphical depiction of the
capital asset pricing model (CAPM).
Under/over pricing

(6 marks for the explanations + 2 marks for the diagram/s)

[25 marks in total]

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QUESTION A3

Part a)

Note: rounding errors are allowed. Full marks will be given for the method used and actual
final numbers can be different.

i)

Assuming constant growth rate in dividends:

+ 4 160,000
= ( ) 1 = ( 85,000 ) 1 . %

By constant dividend growth model:

0 (1+) 0.32(1+0.171)
= + = + 0.171 %
, 1.8

(1mark for growth + 2 marks for ke)

ii)

Time CF PVF@17% PV@17% PVF@18% PV@18%

0 -75 1 -75 1 -75

1 to 6 10 3.589 35.89 3.498 34.98

6 105 0.390 40.95 0.370 38.85

NPV 1.84 -1.17

By interpolation method:

1 1.84
= 1 + (2 1 ) = 0.17 + (0.18 0.17) 17.6%
1 2 1.84 + 1.17

(8 marks)

(3 marks for NPV1 + 3 marks for NPV2 + 2 marks for IRR. Note: rounding errors are
allowed and full marks will be given for the method used and actual final numbers can be
different).

iii)

So,cum per share =2.12; = 0.32; So,XD = 2.12 0.32 = 1.8 per share

Equity total market value 500,000 * 1.8 = 900,000

120,000
Debt total market value (85 10) = ,
100

(2 marks)
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 + (1 ) (0.38 900,000) + [(1 0) 0.176 90,000]
= =
+ 900,000 + 90,000
357,840
= 36%
990,000

(2 marks)

Part b)

i)

(1+) 20 (1+0.04) (1+0.04) 21.632

= + = + 0.04 = + 0.04 = .
So, 12020(1+0.04) 99.2

ii)

Using &2 , the above cost of equity can be ungeared

= + (1 )( )

1
0.2581 = + (1 0.4)( 0.1) 2

2 x 0.2581 = 2 + 0.6( 0.1)

0.5162 = 2 + 0.6 0.06

2.6 = 0.5162 + 0.06

= 0.2216 or 22.16%

iii)

Using &3

= [1 ( )]
+

1
= 0.2216 [1 (0.4 )]
1+2

= 0.2216 = 0.1921 . %
The headline answer is to take the project because its IRR does exceed WACC. But
decision is very close, so caveats about cash flow prediction accuracy and correct
formulation of discount rate are heightened.

(10 marks)

(2 marks for calculating Ke + 4 marks for deducing p + 2 marks for computing WACC + 2
mark for the decision. Note: full marks will be given for the method used and actual final
numbers can be different).

[25 marks in total]

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 SECTION B

QUESTION B1

Student responses could vary, but should at least cover:

Part a

Just-in-Time (JIT), a system imported from Japan is a management philosophy that is a

response to two key factors: the reduction in product life cycles; and the increase in levels
of quality required from demanding customers. In essence, it means that production and
purchasing are linked closely to sales demand on a day-to-day basis, avoiding the need to
hold buffer stocks to see the business through unexpected demand peaks. Although at
first sight JIT is a technique of stock and production control, its effective implementation
requires the acceptance of a particular philosophy and culture. An effective JIT system
requires a flexible attitude on the part (and close attention to quality of outputs at each
stage) both of suppliers and of the internal workforce, to expand and contract output at
short notice. A guaranteed quality is needed, in order for the stocks to arrive just in time
and to go straight into production. Similarly, high levels of quality must follow through each
stage of production and into sales. For the process to function efficiently, a short
geographical distance is probably important, so that deliveries can be made frequently
and at short notice. An effective system of JIT also requires flexibility in the working hours
of a workforce from one period to another, which could be an issue (and fairly expensive),
particularly in western countries. It could be said that the increasing popularity of the JIT
approach implies that many businesses consider the policy as having net benefits, such
as:
A lower level of investment in working capital, since inventory levels have been
minimised;
A reduction in inventory holding costs - these costs can be reduced to a
minimum if a company orders supplies only when it needs them, avoiding the
need to have any inventory at all of inputs to the production process;
A reduction in material handling costs, due to improved materials flow through
the production process;
A better relationship with suppliers, since both parties (customers and suppliers)
need to work closely together in order to make JIT procurement a success. This,
however, requires that the customer is prepared to guarantee only to buy from
the one supplier in respect of a particular stock item and to give the supplier
access to the customers production/sales plans. This fact could be seen as a
disadvantage, because the customer cannot (at least in the short term) buy from
different suppliers according to price.
Operating efficiency also improves, due to the need to streamline production
methods in order to eliminate inventory between different stages of the
production process;
Lower reworking costs due to the increased emphasis on the quality of supplies,
since hold-ups in production must be avoided when inventory between
production stages has been eliminated.
(13 marks)

(6 marks for explaining JIT + 6 marks for the benefits of JIT+ 1 mark for wider reading and
for producing a cohesive answer)

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 Student responses could vary, but should at least cover:

Part b

Risk management is a process for identifying, assessing and prioritising risks of different
kinds (such as, technological, economical, performance, legal and financial risks)
In recent years, risk management has come to included not only firms specific risk
exposure, but also market all types of risk exposures, such as interest rate, commodity
and currency risk exposures

Two main categories of strategies: non-hedging strategies, and hedging strategies

Non-hedging strategies:
o Acquisition of additional information
In many cases the risk arises because of lack of information. But, it is costly
to collect additional information. Firms that want to maximise firm value will
pay for the additional information only if the marginal value of that
information is expected to exceed the marginal cost of acquiring it.
o Diversification
We have seen the power of diversification. Practically speaking firms can
diversify their customers and supplier not to depend only on particular ones.
The more, the better.
o Insurance
Available to minimise the risk of fire, fraud, thefts etc.
o Gaining control over the operating environment
The use of patents and copyrights may protect a firm against immediate
competition
o Limited use of firm-specific assets
The more general the purpose of the assets employed by a firm, the less the
risk taken by that firm, because the assets can be used for more than one
purpose
Hedging strategies:
o When the firm reduces its risk exposure with the use of derivatives it is said to be
hedging
o Derivatives include: forward contracts; futures contracts; swaps, and options

(12 marks)

(2 marks for the definition + 5 marks non-hedging strategies + 4 marks for hedging
strategies + 1 mark for other wider reading and for producing a cohesive answer)

[25 marks in total]

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QUESTION B2

Student responses could vary, but should at least cover:

Market efficiency refers to a condition, in which current prices reflect all the publicly
available information about a security.
In an efficient market, any new information will be incorporated into the market price of
the share: quickly, and rationally, in terms of size and direction of share price
movement.
The basic idea underlying market efficiency is that competition will drive all information
into the price quickly.
o It is assumed that in an efficient market, a large number of analysts are
assessing the true value of firms.
o To try to find stocks that are mispriced, to buy or sell.
o Competition in the stock market pushes prices to their true value.
Types of market efficiency:
o Informational (pricing) efficiency
Refers to the notion or understanding that current market prices instantly
and fully reflect all relevant available information.
Often construed as the Efficient Market Hypothesis (EMH).
o Operational efficiency
Refers to the level of costs of carrying out transactions in capital markets in
the most cost-effective way.
o Allocational efficiency
Refers to the extent to which capital is allocated to the most profitable
enterprise, and should be a proud of pricing efficiency.
o Market is said to be efficient when it is simultaneously allocationally,
operationally, and informationally efficient.
Fama (1965, 1970)
Weak form security prices instantly and fully reflect all information contained in
the past history (prices of security, volume of trade, trends, graphs etc.) of security
prices. No abnormal returns could be predicted by looking at the history of past
price movements.
Random walk hypothesis
Empirical tests:
o Auto correlation (serial correlation)
o Runs test
o Chartist
o Filter rule
Auto correlation a test that investigates whether security returns are related
through time. This analysis tends to confirm that share returns are independent
through time.
Runs test - a nonparametric statistical technique to test the likelihood that series of
price movements occurred by chance. It is an uninterrupted sequence of the same
observation.

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 Chartist weak form suggests that reading charts of past prices or patterns should
no lead to excess returns, except by chance. Chartists believe otherwise history
tends to repeat itself.
Filter rule classic example of trading strategy based on past price information: if
price increases by some pre-determined percentage, buy; hold until price moves
down by some other pre-determined percentage below intervening high at which
point SELL the share and go short.
Semi-strong form security prices instantly and fully reflect all past and publicly
(past price movements, trading volume, company fundamentals, company events,
macroeconomic information) available information. It is useless to analyse publicly
available information as it is rapidly incorporated into security prices.
Empirical tests:
o Event studies examine the behaviour of share prices following company
announcement.
Strong form security prices instantly and fully reflect all available (past, public and
private) information.
Tested by studies based on observing market participants who might reasonably be
expected to have access to private information, or those with the expertise and
resources to generate such.
Empirical tests:
o Managed funds
o Company insiders
o Financial analysts
Managed funds use CAPM and OLS regression to measure the excess return on
CAPM framework. Absence of excess return to managed funds taken to be
evidence supporting strong form of EMH. Often any excess returns detected are
offset by fees, etc.
Company insiders using directors/managers share purchases, looks at the
effects of share purchases by director and managers (insiders) of their companies.
Insider trading laws require insider trading to be registered publicly.
Financial analysts using information content of analysts forecasts, as they tend to
have greater access to insider information, and their recommendations are not
necessarily made public. Hence, it might be possible for certain investors to make
excess profits based on their recommendations.
Empirical research findings generally do not support the strong form (there has not,
however, been any direct test).

(5 marks for the definition and facets of market efficiency + 5 marks for each form
(including explanation of tests) + 5 marks for referencing to academic articles or other
wider reading and for producing a cohesive answer)
[25 marks in total]

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QUESTION B3

Student responses could vary, but should at least cover:

Part a

M&M1

In the absence of taxation, the market value of any firm is independent of its capital
structure and is given by the present value of its expected net operating income
discounted at the rate appropriate to its risk class.

In the presence of corporate taxation, the market value of a levered firm exceeds the
value of the equivalent unlevered firm by an amount equal to the market value of its debt
multiplied by the corporation tax rate it faces.

M&M2

In the absence of taxation, a firms cost of equity increases linearly with increasing
leverage (as measured by the ratio of market value of its debt to market value of its
equity); the slope of the increase being the excess of the all equity financed rate ()
appropriate to its risk class above the cost of debt, kd.

Similarly in the presence of corporate taxation, but with the slope of increase of the firms
cost equity being reduced by a factor of (1-tc) as compared to the no taxation case.

M&M3

In the absence of taxation, a firms weighted average cost of capital is equal to the all
equity financed rate () appropriate to its risk class.

In the presence of corporate taxation, a firms WACC decreases with increasing leverage
(as measured by the ratio of market value of its debt to total market value of the firm);
asymptotically towards a limit being the all equity financed rate () appropriate to its risk
multiplied by one minus the corporation tax rate it faces.

Summary no tax

No risk of bankruptcy so kd curve is flat; linear increase in ke due to increasing financial

risk.
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 As company gears up and replaces equity with debt, benefit of cheaper debt is exactly
balanced by the increasing cost of equity, so WACC is flat; there is no so-called optimal
capital structure.

Summary with tax

Tax efficiency implies that gearing up by replacing equity with debt gives benefit of a tax
shield, increasing the value of company.
kd curve falls from before-tax to after-tax level, so WACC curve slopes downwards.
This implies an optimal capital structure does exist: i.e. gear up with as much debt as
possible.
(18 marks)

(9 marks for explaining M&M1, M&M2, and M&M3 + 7 marks for diagrams, formulas and
explanations + 2 marks for producing a cohesive answer)

Student responses could vary, but should at least cover:

Part b

Clientele effect
o Shareholders may prefer companies to supply them with a dividend pattern which
matches their desired consumption pattern, thereby relieving them of having to
adjust this cash flow themselves.
o In practice, companies often do this by following a stable and easily identifiable
dividend policy.
o Shareholders whose own consumption pattern closely follows the dividend pattern
of the company will be attracted by the knowledge that they are unlikely to need to
resort to the imperfect capital market in order to make dividend/consumption
pattern adjustments.
o So in such circumstances, it could be argued that the best approach that a
company can take is to follow a consistent dividend policy, which is often referred
to as arising from the clientele effect.
o By following a consistent dividend policy, the company attracts to it a clientele of
shareholders whose consumption pattern accords with the dividend pattern.

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 Signalling theory
o Capital markets could be imperfect in that information is neither costless nor
universally available, and so decisions have often to be made on the basis of
imperfect and incomplete information: information asymmetry.
o Thus a companys dividend declaration which is free and universally available is
often thought to signal information about its future performance.
o If the stock market places such an informational content on the dividend
declaration, then a company cannot ignore its impact.
o Dividend decisions could be interpreted by the market as signals for availability of
positive NPV projects, growth, or business life-cycle.
(7 marks)

(4 marks for clientele effect + 3 marks for signalling effect)

[25 marks in total]

END OF PAPER

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