AC3059 ZB

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN EDUCATION IN SOCIAL SCIENCES

Summer 2021 Online Assessment Instructions

AC3059 Financial Management

Wednesday 5th May 2021, 06:00-12:00 (BST)

The assessment will be an open-book take-home online assessment within a 6-

hour window. The requirements for this assessment remain the same as the closed-
book exam, with an expected time/effort of 3 hours.

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

Workings MUST BE submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

You may use spreadsheet software to obtain your solutions but please do not upload
spreadsheets.

You may use any calculator for any appropriate calculations. Credit will only be given if
all workings are shown.

You should complete this paper using word processing software (eg. Microsoft Word).
This should be saved as a .doc or .docx file and then uploaded to the VLE as ONE
individual file including the coversheet. Each page should have your candidate
number in the header. Please do not write your name anywhere on any part of your
submission.

You may hand-write calculations, formulae, or diagrams, but these should be scanned
or copied and included as images in the Word document that you submit. Please
ensure that any images are inserted at the appropriate point of your document and
correctly aligned (i.e. markers will not need to rotate images to read them).

© University of London 2021

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You have until midday 12:00 (BST) Wednesday 5th May 2021 to upload your file into
the VLE submission portal. However, you are advised not to leave your submission to
the last minute.

If you think there is any information missing or any error in any question, then you
should indicate this but proceed to answer the question stating any assumptions you
have made.

The assessment has been designed with a duration of 6 hours to provide a more
flexible window in which to complete the assessment and to appropriately test the
course learning outcomes. As an open-book exam, the expected amount of effort
required to complete all questions and upload your answers during this window is no
more than 3 hours. Organise your time well.

You are assured that there will be no benefit in you going beyond the expected 3 hours
of effort. Your assessment has been carefully designed to help you show what you
have learned in the hours allocated.

This is an open book assessment and as such you may have access to additional
materials including but not limited to subject guides and any recommended reading. But
the work you submit is expected to be 100% your own. Therefore, unless instructed
otherwise, you must not collaborate or confer with anyone during the assessment. The
University of London will carry out checks to ensure the academic integrity of your work.
Many students that break the University of London’s assessment regulations did not
intend to cheat but did not properly understand the University of London’s regulations
on referencing and plagiarism. The University of London considers all forms of
plagiarism, whether deliberate or otherwise, a very serious matter and can apply severe
penalties that might impact on your award. The University of London 2020-21
Procedure for the Consideration of Allegations of Assessment Offences is available
online at:

Assessment Offence Procedures - University of London

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SECTION A

Answer four questions from this section.

Question 1

An entrepreneur wants to raise outside financing to undertake an investment. The

investment costs $80m today. Next year, the investment will generate cash flows which
depend on whether the entrepreneur exerts effort. If the entrepreneur exerts effort,
cash flows will be $120m or $70m with equal probability. When the entrepreneur does
not exert effort, cash flows will be equal to $100m or $50m with equal probability, but
the entrepreneur receives a private benefit worth $5m. This private benefit cannot be
transferred to investors.

For all parts of this question, assume that the entrepreneur and investors are risk
neutral and that the time discount rate is zero. Further assume that capital markets are
very competitive.

Consider first equity financing.

a) Assuming that the entrepreneur exerts effort, what proportion of equity  would she
have to sell to outside investors to fund the project?
(4 marks)

b) Given the funding terms calculated in part a), does the entrepreneur have incentives
to exert effort? Explain.
(4 marks)

c) Based on a) and b), is it possible to finance the project with equity? Explain.
(2 marks)

Consider next debt financing.

d) Assuming that the entrepreneur exerts effort, what face value of debt K (i.e. total
promised repayment) does she have to offer to raise financing for the project?
(4 marks)

e) Given the funding terms calculated in part d), does the entrepreneur have incentives
to exert effort? Explain.
(4 marks)

f) Based on d) and e), is it possible to finance the project with debt? Explain.
(2 marks)

[Total: 20 marks]

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Question 2

Answer all parts of this question.

a) Suppose a firm announces positive earnings growth in the latest quarter and its
price does not change. Explain whether this is consistent or not with either the
weak or the semi-strong versions of the Efficient Market Hypothesis?
(5 marks)

b) Adagio Corporation has return on equity (ROE) of 20% and its plowback ratio is
p. The ROE and the plowback ratio are expected to stay the same in all future
periods. The company's earnings are expected to be £4 per share next year.
The cost of capital is 15%. What is the present value of growth opportunities of
this corporation as a function of p? Calculate the present value of its growth
opportunities for p = 30%.
(5 marks)

c) Consider three portfolios A, B, and C. All three portfolios lie on the efficient
frontier which allows for risk-free investments. Portfolios A and B have the
following expected returns and standard deviations of returns:

E(r) STD
A 6% 10%
B 8% 15%

i. If Portfolio C has an expected return equal to 12%, what are its Sharpe
ratio and standard deviation of returns?

ii. What is the risk-free interest rate in the economy?

(5 marks)

d) If an investor can construct a portfolio of stocks that has a long-run mean return
that is reliably above the mean return on the market, is this evidence that the
investor has some skill in picking stocks? Justify your answer.
(5 marks)

[Total: 20 marks]

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Question 3

Assume that you are the owner of Scorpius, a company which has debt maturing next
year with a face value equal to €100m. Current operations of Scorpius will produce two
possible cash flow outcomes next year when the debt is due: either €130m with
probability 60% or €60m with probability 40%. There is no further production after the
next year. Assume risk neutrality and no discounting.

Required:

a) Based on the information provided, what is the market value of debt and equity in
efficient capital markets?
(4 marks)

b) Now suppose you have an opportunity to invest another €20m that can yield
additional €25m with certainty on top of the currently projected outcomes. What
is the NPV of this additional investment? What is the market value of debt and
equity after the investment? If you, as the owner, have to fund the investment
out of pocket, should you invest?
(5 marks)

c) Explain your intuition for part b) without using any calculations.

(4 marks)

d) If you instead issued debt that is more senior than the current debt to finance the
new investment, what is the face value of the new debt? What are the market
values of the original debt and equity claims? Should you issue this debt and
invest? Explain.
(7 marks)

[Total: 20 marks]

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Question 4

Assume a Modigliani-Miller (MM) world. Gemini Ltd. is an all-equity firm with 10 million
shares outstanding. Its only asset is $100 million of cash invested in the risk-free asset,
which pays 10% per year. Gemini can invest $50 million of its cash today into one of
two mutually exclusive projects, A or B. Project A is expected to generate a perpetual
stream of free cash flows, starting with $13.5 million in exactly one year, thereafter
growing at an expected rate of 3% per year. Project B, also perpetual, is expected to
produce a free cash flow of $10 million in exactly one year’s time, growing at an
expected rate of 5% per year thereafter. The risk of both projects is diversifiable.

State any additional assumptions you may need to make when answering the question.
Show all working and calculations.

Required:

a) Calculate the NPV and IRR of each project. If the NPV and IRR rankings
disagree, explain the source of the conflict.
(5 marks)

b) Which project should Gemini choose? Why?

(4 marks)

c) Assume Gemini invests in project B. What is the firm’s new share price after
investment?
(2 marks)

After taking project B, Gemini considers acquiring Leo Corp., an all-equity firm with 20
million shares outstanding, currently trading at $2 per share. The difficulties of
integrating disparate organizations means the synergies from the acquisition are
uncertain. With probability 60%, integration will be successful, in which case the value
of Leo’s assets will improve by 30% under the new management. However, if the
merger is implemented poorly (probability 40%), the acquisition will destroy 20% of
Leo’s asset value.

Remember that information in an MM world is symmetric – insiders at firms and in the

market are equally informed about the synergy outcome, which will only be revealed
after the acquisition is completed. Assume managers always act in the interest of
existing shareholders and that all participants are risk-neutral. Also assume that in any
takeover, 100% of target shares are acquired by the bidder.

d) Assume Gemini does not have to pay a premium to acquire Leo. Advise Gemini
on the merits of the acquisition. If it financed the takeover using shares in the
combined entity, how many shares will Gemini need to offer for each Leo share?
Would Gemini’s shareholders be better off (in expectation) if the acquisition was
financed using cash from the company accounts instead? Explain.
(5 marks)

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 e) For each payment method (i.e. shares vs cash), determine the post-acquisition
wealth of Gemini and Leo shareholders in the good and bad synergy states.
What do your calculations say about how the method of payment affects how the
risks from an acquisition are shared between bidder and target shareholders?
(4 marks)

[Total: 20 marks]

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Question 5

Answer all parts of this question.

a) Today you have purchased one tonne of palladium for price S. You are
concerned that the price per tonne of palladium is going to fall over the next few
months and wish to protect against this eventuality. You decide to use a put
option written on palladium, with exercise price S and 3 months to maturity, to
deliver this protection. Show analytically how the put option, when held in
conjunction with the position in the underlying palladium, helps you achieve your
goal. Be clear about how the option premium, p, affects your trading profit.
(4 marks)

b) You wish to arrange a forward purchase of 1 unit of some commodity with

delivery in 3 months. The spot price of this commodity is £350 per unit and the
stated 3-month interest rate is 4%. If the commodity costs £10 per quarter to
store (payable at the end of the period), develop an arbitrage argument which
allows you to work out the delivery price you should be prepared to pay in 3
months.
(4 marks)

c) Consider a firm with assets currently worth $400m. The assets’ worth could
increase to $520m with probability 20% or decrease to $320m with probability
80% in one year’s time. The firm has a debt with face value of $380m maturing
at that time. The risk-free rate is equal to 10% per year.

i. What are the firm’s debt and equity currently worth?

(6 marks)

ii. How would your answers to part i. change if the firm committed to
pay a dividend equal to $20m shortly before the debt was
maturing?
(6 marks)

[Total: 20 marks]

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Question 6

Carillion Plc was one of the UK’s leading companies in the construction sector and
provided integrated support services to other companies. The company had projects
ongoing in the UK, Canada and the Middle East. The company filed for compulsory
liquidation in January 2018. Carillion grew through a series of acquisitions, and took on
multiple public projects in the public sector. As a result of this, Carillion had high levels
of goodwill on its balance sheet. In the annual report of December 2016, Carillion
affirmed that “the Directors believe that they have a reasonable expectation that the
Company will be able to continue in operation and meet its liabilities as they fall due
over the three-year period of their assessment”. Further, the company decided not to
note down any impairment losses in 2016. The auditors agreed with this assessment of
the company, and agreed with the company’s decision to not take an impairment
charge in 2016 and signed off on the auditor’s report.

However, following the appointment of a new finance director who identified problems
with certain accounting techniques, a detailed review of the financial statements was
conducted. Based on this review, the company released information that there would
be an impairment loss of £845 million, which was further updated to be £1,045 million.
Due to these large impairment losses, naturally the expected profits went down
significantly. The announcement of this profit warning led to loss of confidence by
investors and lenders. The firm was forced to declare bankruptcy in January 2018.

You are an analyst asked to evaluate the performance of Carillion for the last several
years in order to explain the reasons for the company’s decline. To do this, please go
over the company’s financials and ratios.

2008 2009 2010 2011 2012 201 2014 2015 2016

3
Profitability Ratios
Gross Margin (%) 8.2 7.8 8.3 9.4 10.6 10.4 9.4 8.6 8.0
Operating Margin 1.4 2.0 2.8 3.4 4.1 2.4 4.6 3.7 3.0
(%)
Return on Assets (%) 4.0 3.8 4.7 3.9 4.2 2.7 3.2 3.4 3.0
Return on Equity (%) 15.9 14.8 18.2 14.7 16.2 10.2 13.1 14.2 14.7
Liquidity Ratios
Current Ratio 0.83 0.77 0.84 0.90 1.09 1.01 1.03 1.02 1.02
Quick Ratio 0.63 0.57 0.82 0.86 1.5 0.98 1.00 0.98 0.96
Cash Ratio 0.14 0.15 0.23 0.27 0.40 0.26 0.27 0.27 0.22
Gearing Ratios
Gearing Ratio 0.49 0.25 0.26 0.52 0.78 0.63 0.70 0.60 0.84
Interest Coverage 4.1 6.2 10.1 7.2 2.4 3.3 4.1 3.6 3.4
Efficiency Ratios
Receivables 25.6 29.9 25.0 24.7 42.9 64.9 67.1 60.9 61.6
Settlement Period
Inventory 3.4 3.6 3.7 5.4 7.1 6.4 5.7 5.8 6.5
Holding Period
Shareholder Ratios

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Earnings per Share 0.28 0.30 0.36 0.32 0.34 0.23 0.25 0.28 0.26
Dividends per Share 0.12 0.14 0.14 0.16 0.17 0.17 0.17 0.18 0.18

2010 201 2012 201 2014 201 2016

1 3 5
Non-Current Assets (£m)
Net Property, Plant, and 157 134 127 128 141 141 144
Equipment
Goodwill and Intangible Assets 1221 154 1540 155 1611 163 1669
7 3 4
Deferred Income Taxes 101 137 121 113 143 104 164
Total Assets (£m) 3153 369 3862 364 3890 387 4433
9 0 0

Cash Flow Statement (£m) 2010 2011 201 2013 2014 2015 2016
2
Net Cash from Operating Activities 126 103 -26 -78 124 73 73
Net Cash from Investment 31 -136 14 107 1 26 0
Activities
Net Cash from Financial Activities -22 130 178 -266 -72 -105 -84

Required:

a) How has Carillion been performing over the years?

(5 marks)

b) Identify the flux years (years in which performance drastically went down or up).
(3 marks)

c) What percentage of total assets did goodwill and other intangible assets
comprise of? Does this percentage matter? Explain.
(3 marks)

d) Was the company correct in paying dividends until 2016? Explain.

(3 marks)

e) What do you think caused the liquidation (bankruptcy) of Carillion? Identify

factors by looking at the financial information over several years prior to the
liquidation.
(6 marks)

[Total: 20 marks]

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SECTION B

Answer one question from this section.

Question 7

Discuss the attractiveness of leveraged buyouts in industries according to the

magnitude of agency costs of debt and agency costs of free cash flows.

[Total: 20 marks]

Question 8

How would you assess empirically the likelihood of a firm getting into financial distress?

[Total: 20 marks]

END OF PAPER

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