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Ac3059 2017

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0% found this document useful (0 votes)

38 views48 pages

Ac3059 2017

Exam Papers

Uploaded by

kishwarya01

We take content rights seriously. If you suspect this is your content, claim it here.

Available Formats

Download as PDF, TXT or read online on Scribd

You are on page 1/ 48

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON AC3059 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences

Financial Management

Friday, 19 May 2017: 10:00 to 13:00

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

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

Extracts from Present Value Tables are given after the final questions of this paper.

8-column accounting paper is provided at the end of this question paper. If used, it must
be detached and fastened securely inside the answer book.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.

PLEASE TURN OVER

Answer FOUR questions from this section.

1. Roland plc manufactures high quality vehicle tyres. It has just won a contract to supply 80,000
mud track tyres to the car manufacturer, Toyota, for the next eight years. The company will
need to purchase new equipment for this purpose, although existing factory space with a book
value of £6,800,000 will be used as the manufacturing site, and is evaluating the two options
posed below.

Option 1:
The equipment will cost the company £5,600,000, payable immediately. It has a life of 4 years,
and is not expected to generate a resale value at the end of its life.

Costs associated with the manufacture of the tyres using this equipment are as follows:

Cost per unit (£)

Materials 16
Labour 8
Variable overhead 10

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been
estimated at £2,000,000.

Option 2:
The equipment will cost the company £8,000,000, payable immediately. It has a life of 8 years,
and is estimated to generate a scrap value of £800,000 at the end of its life.

Costs associated with the manufacture of the tyres using this equipment are as follows:

Cost per unit (£)

Materials 17
Labour 7
Variable overhead 12

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been
estimated at £3,000,000.

In addition, given the technical advancement of this equipment, the company will incur training
costs worth £200,000 in its first year. This cost will not be repeated in subsequent years.

For both options, the company will need a working capital investment worth £1,000,000. This
will be recovered at a rate of 90% when the contract with Toyota comes to an end in 8 years
time.

Further, it is company policy to allocate 10% of head office costs to individual projects. Annual
head office costs currently stand at £1,000,000.

Roland plc has a cost of capital of 12%.

Question continues on next page.

© University of London 2017

Page 2 of 10 D0
UL17/0144
REQUIRED:

(a) For the benefit of management at Roland plc, determine which equipment option will be
more cost effective for the company.
(14 Marks)

(b) Explain the implications of each of the following on your decision in (a) above (you are
not expected to conduct any further computations):

i. Toyota, Roland plc’s customer, delayed the start of the contract by 12 months;

ii. The equipment in Option 2 did not generate a scrap value; and

iii. Toyota extended the contract for another 8 years.

(6 Marks)

Note: assume all cash flows take place at the end of the year, unless otherwise stated. Ignore
taxation and inflation.

© University of London 2017

Page 3 of 10 D0
UL17/0144
2. Orian plc reviews its credit policy at regular intervals. Its current policy offers customers a 60
days credit period with a discount of 2% for all payments settled within 30 days. 30% of its
customers take advantage of the discounting facility and the remainder pay on average in 70
days. Bad debts currently stand at 3% of annual sales. The sales forecast for next year is
£1,200,000 assuming this credit policy is maintained.

Two new policy proposals have been put forward by the senior management team. They are
as follows:

Proposal 1
The finance director has called for the policy to be tightened. He 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. Only 15% of customers, it would be expected, would take
advantage of the discounting facility and the remainder of customers would pay on average in
45 days. Bad debt will fall to 2% and annual sales forecast is not expected to change under
this policy. To tighten the policy, the company would incur costs of £25,000.

Proposal 2
The marketing director takes an opposing view and she suggests that the policy should be
relaxed to attract more customers. She proposes that customers be offered a 3% discount for
all payments settled within 30 days. 40% of customers would be likely to take advantage of the
discounting facility. Policy for the remainder will be lax and they are likely to pay on average in
90 days. This proposal is likely to be attractive to the market and the marketing team forecast
sales will rise by 20% if this policy is introduced. They accept it may attract high risk customers
and propose that provision for bad debt be set to 6% of annual sales.

Orian plc earns a contribution of 25% on sales revenue and its cost of capital has been
estimated at 10% per annum.

REQUIRED:

(a) Explain what working capital management refers to and discuss the importance of a
working capital management policy for companies.
(5 Marks)

(b) Advise Orian plc, which of the two plans, if either to adopt.
(15 Marks)

© University of London 2017

Page 4 of 10 D0
UL17/0144
3. Angel plc and Cherub plc are two companies that both operate in the brewery industry. Within
the industry, both companies undertake similar activities and experience the same risk. While
Angel plc is an all equity company, Cherub plc is financed by a combination of debt and equity.
Details of their financial structures and cash flow situations follow.

Cherub plc has 200 million shares with nominal and current market values of £1.00 and £2.40
(ex div.) respectively. The company also has 6% irredeemable debt of £120 million, currently
valued at par. Angel plc, on the other hand, has 400 million shares, valued at £2.00 (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.

Marissa owns 40,000 shares in Angel 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. Marissa has, however, been told by a friend that she could generate a
better return by changing her investment from Angel plc to Cherub 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 Cherub plc and Angel plc. Comment on your results.
(8 marks)

(b) Calculate Marissa’s current financial position and show whether, and if so how, she can
improve this financial position by moving her investment from Angel plc to Cherub plc
without changing the risk class of her total holding.
(7 marks)

(c) Briefly explain the effect of transactions you propose in (b) above on the share prices of
Angel plc and Cherub plc and identify two factors that may prevent an investor like
Marissa from moving her investment.
(5 marks)

© University of London 2017

Page 5 of 10 D0
UL17/0144
4. Butterfly plc is financed by a combination of debt and equity. The company has £150m 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 £20 million for a guarantee d
cash flow of £40 million at the end of the financial year. The capital for this investment will have
to come from the company’s equity holders. The firm also has in place other assets that
generate some cash flows. The level of cash flows from these assets is dependent upon the
state of the economy, of which there are 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 0.3 0.4 0.3
Cash flow from assets 90 120 150
already in place (£m)

REQUIRED:

(a) Assuming that the company operates purely in the interests of its current equity holders,
determine whether it should proceed with the project.
(7 Marks)

(b) Revisit the position in (a) above if the company’s debt was only £90m.
(3 Marks)

(c) Explain: why management may operate in the interests of equity holders rather than
debtholders; the underinvestment problem for firms in the context of capital structure
decisions; and agency problems between debt- and equity holders; and compare and
contrast the decisions in (a) and (b) above.
(10 Marks)

© University of London 2017

Page 6 of 10 D0
UL17/0144
5. Answer all parts of this question.

(a) Consider a stock with a current price of $120. This stock is not expected to pay any
dividend over the next three months.

i. What is the price of a 3 month forward contract on this stock assuming that the risk-
free rate over the next three months is 5%.
(7 marks)

ii. How would your answer change if the stock was expected to pay $10 of dividends
in three months time just before maturity of the forward contract?
(3 marks)

(b) A non-dividend paying stock is currently priced at £20. In each of the next two periods,
it could either rise in price by 30% or fall in price by 29%. The one-period interest rate
is 10%. A derivative exists that promises a payoff of £5 if, at the end of the second
period, the price of the stock is above £16 and nothing otherwise. Compute the possible
price paths of the stock and the possible payoffs of the derivative, and proceed to price
the derivative using the risk-neutral method.
(10 marks)

6. Your company has earnings per share of £4. It has 1 million shares outstanding, each with a
price of £40. You are thinking of buying BoostCo, which has earnings per share of £2, 1
million shares outstanding, and a price per share of £25. You will pay for BoostCo by issuing
new shares. The synergy as a result of this acquisition will increase your original company’s
EPS and share price by 25%.

REQUIRED:

(a) If you do not pay any premium to buy BoostCo, what will your earnings per share be
after the acquisition?
(8 marks)

(b) Assuming instead that you pay a 20% premium to buy BoostCo:

i. What will your earnings per share be after the acquisition?

(3 marks)

ii. Are you better off with this acquisition? Explain.

(3 marks)

(c) What is the maximum percentage premium you are willing to pay before BoostCo
becomes too expensive to acquire?
(6 marks)

© University of London 2017

Page 7 of 10 D0
UL17/0144
SECTION B

Answer ONE question from this section.

7. Describe and critically evaluate the use of financial ratios to assess the leverage of a publicly
quoted company.
(20 marks)

8. Critically assess the following theories of dividend policy and discuss their relevance to the real
world:

a. Modigliani and Miller Irrelevance Theory;

b. Agency Cost Theory;
c. Dividend Clientele Theory.
(20 marks)

END OF PAPER

© University of London 2017

Page 8 of 10 D0
UL17/0144
PRESENT VALUE TABLE

Present value of $1, that is (1+ r )

−n
where r = interest rate; n = number of periods until
payment or receipt.
Periods Interest rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

 The Chartered Institute of Management Accountants 2010

UL17/0144 Page 9 of 10
annuity—> if years stated
Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
1−(1+ r )− n
years r

Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

UL17/0144 Page 10 of 10
~~AC3059_ZB_2016_d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON AC3059 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences

Financial Management

Friday, 19 May 2017: 10:00 to 13:00

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

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

Extracts from Present Value Tables are given after the final question of this paper.

8-column accounting paper is provided at the end of this question paper. If used, it must
be detached and fastened securely inside the answer book.

PLEASE TURN OVER

© University of London 2017

UL17/0145 Page 1 of 11 D0
SECTION A

Answer four questions from this section.

1. Orland plc manufactures high quality vehicle tyres. It has just won a contract to supply 80,000
mud track tyres to the car manufacturer, Toyota, for the next eight years. The company will need
to purchase new equipment for this purpose, although existing factory space, with a book value
of £6,800,000, will be used as the manufacturing site and is evaluating the two options posed
below.

Option 1:
The equipment will cost the company £5,200,000, payable immediately. It has a life of 4 years,
and an estimated scrap value at the end of this period of £800,000.

Costs associated with the manufacture of the tyres using this equipment are as follows:

Cost per unit (£)

Materials 14
Labour 8
Variable overhead 9

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been
estimated at £2,000,000.

Option 2:
The equipment will cost the company £8,800,000, payable immediately. It has a life of 8 years,
and is not expected to generate a scrap value at the end of its life.

Costs associated with the manufacture of the tyres using this equipment are as follows:

Cost per unit (£)

Materials 14
Labour 6
Variable overhead 12

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis) have been
estimated at £3,000,000.

In addition, given the technical advancement of this equipment, the company will incur training
costs worth £400,000 in its first year. This cost will not be repeated in subsequent years.

For both options, the company will need a working capital investment worth £1,000,000. This will
be recovered at a rate of 90% when the contract with Toyota comes to an end in 8 years time.

Further, it is company policy to allocate 10% of head office costs to individual projects. Annual
head office costs currently stand at £1,000,000.

Orland plc has a cost of capital of 12%.

Question continues on next page

© University of London 2017

UL17/0145 Page 2 of 11 D0
REQUIRED:

(a) For the benefit of management at Orland plc, determine which equipment option will be
more cost effective for the company.
(14 Marks)

(b) Explain the implications of each of the following on your decision in a. above (you are not
expected to conduct any further computations):

i. Head office costs were to rise to £1,200,000 as a result of this new contract;

ii. The equipment in Option 1 did not generate a scrap value; and

iii. Toyota, the customer was to extend the contract for another 8 years.

(6 Marks)

Note: assume all cash flows take place at the end of the year, unless otherwise stated. Ignore
taxation and inflation.

© University of London 2017

Page 3 of 11 D0
UL17/0145
2. Orio plc is an all equity company (worth £80 million) that operates in the brewery industry. It is
considering diversifying its business activities into the food and beverage industry through the
acquisition of Chai Ltd. The company expects to generate synergistic benefits of £2.5 million
per annum into perpetuity and hopes to secure the acquisition at a net price of £20 million,
payable immediately.

The finance director has compiled the following information about Orio plc to enable
management to evaluate the worthiness of the acquisition. The curr ent beta of Orio plc is 1.2
and the risk free rate of interest and the return on the market portfolio are 2% and 12%,
respectively.

A trainee in the finance department believes that it is inappropriate to use the details of Orio
plc to evaluate the acquisition of Chai Ltd. She has gathered the following information about
Coffi-Foud plc, a company that operates in the food and beverage industry. Coffi-Foud plc is
financed by a combination of debt (40%) and equity (60%) and has a debt and equity beta of
0.2 and 1.2, respectively.

REQUIRED:

(a) Explain the benefit of corporate diversification for investors.

(4 Marks)

(b) Calculate the cost of capital at Orio plc using the information compiled by the finance
director and evaluate the worthiness of the acquisition of Chai Ltd. using this information.
(6 Marks)

(d) Comment on the views of the finance director and trainee, specifying whose view you
support.
(4 Marks)

Note: assume all cash flows take place at the end of the year, unless otherwise stated. Ignore
taxation and inflation.

© University of London 2017

Page 4 of 11 D0
UL17/0145
3. Natalia Batteries develops rechargeable batteries for electric vehicles, including an industry-
leading lithium-ion product in production. Natalia is also pursuing a project to develop a long-
lasting lithium-sulphur version of their product. Though lithium-sulphur batteries hold four
times more energy per mass than lithium-ion batteries, current lithium-sulphur batteries have
relatively shorter lifespans because they cannot be charged as many times as lithium-ion
batteries.

Natalia requires an injection of £80m of outside equity capital to invest in the project as no
bank will finance such a risky project. The following table details the outcomes linked to the
four possible states of the world relevant to Natalia’s prospects:

Values in millions of £ State 1 State 2 State 3 State 4

Probabilities 25% 25% 25% 25%
Lithium-Ion Assets 200 200 1160 1160
(Assets in Place)
Investment Cost 80 80 80 80
(Lithium-Sulphur)
NPV 10 30 20 100
(Lithium-Sulphur)

When answering this question, state any additional assumptions you may need to make. Show
your calculations.

REQUIRED:

(a) If Natalia’s managers must issue equity without knowing the state of the world, what
percentage of the firm must original equity holders give up in exchange for the capital?
(6 marks)

(b) Now assume that management knows the true state of the world before the decision to
issue and invest is made. If management is maximizing the wealth of old shareholders
and can sell equity at the terms described in part (a), do they have incentives to use
their inside information when deciding whether to issue equity and invest? Explain.
(4 marks)

(c) Following the argument developed in part (b), explain in which states manage rs,
knowing the true state of the world and maximizing the wealth of old shareholders, elect
not to invest in the lithium-sulphur project.
(10 marks)

© University of London 2017

Page 5 of 11 D0
UL17/0145
4. Answer all parts of this question:

i. Compute the market values of the two firms and the implied present value of
growth opportunities for firm B.
(8 marks)

ii. Explain the source of the difference in the values of the two firms with reference to
the underlying data.
(2 marks)

(b) An investor has access to a set of N securities with N being very large. Each of them
has an annual return variance of 25% and the correlation between every pair of the N
assets is 50%. The investor wishes to build an equally weighted portfolio of these N
assets that has a return variance of 15% or smaller. What is the smallest number of
assets that this portfolio should contain?
(10 marks)

© University of London 2017

Page 6 of 11 D0
UL17/0145
5. Answer all parts of this question:

The finance director has suggested the company use a foreign currency option to hedge
this risk. He has negotiated an over the counter option with an exercise price of £1 : $1.24
and a premium of 0.1% on the dollar value.

i. Assuming that the three month spot rate materialises as £1 : $1.25, determine the
outcome of the hedge.
(4 marks)

ii. Assuming that the three month spot rate materialises as £1 : $1.21, determine the
outcome of the hedge.
(4 marks)

i. Show that this call option is mispriced. Compute the size of the mispricing.
(8 marks)

ii. Devise and explain in detail an arbitrage strategy that generates risk-less profits
from this mispricing. Compute the instantaneous profits from the arbitrage
strategy.
(4 marks)

© University of London 2017

Page 7 of 11 D0
UL17/0145
6. Consider a risk-neutral entrepreneur who has two investment opportunities. Both require an
investment of £100m upfront with the following payoffs in the next year:

A pays £200m with probability 40% and £0m with probability 60%;
B pays £120m for sure.

The risk-free rate is normalised to 0% for your computational convenience.

REQUIRED:

(a) If the entrepreneur has £100m in cash to fund the investment, which project will he
choose? Show your calculations.
(4 marks)

(b) Now suppose that the entrepreneur has no cash and must issue straight debt with one
year maturity to raise the required investment of £100m. If the entrepreneur can commit
to take project B, what is the required face value of debt such that the market value of
debt is £100m?
(4 marks)

(c) Assume that the entrepreneur convinces debtholders that he will take project B even
though no commitment is possible. After the debt is in place, which project will the
entrepreneur choose? Show your calculations.
(6 marks)

(d) If you were a sophisticated bank, anticipating the entrepreneur’s choice of investment
after taking the loan, would you make the loan at any face value? If not, why? If so, at
what face value can you break even?
(6 marks)

© University of London 2017

Page 8 of 11 D0
UL17/0145
SECTION B

Answer one question from this section.

7. Describe and critically evaluate the use of financial ratios to assess the liquidity of a publicly
quoted company.
(20 marks)

8. Critically assess the following theories of dividend policy and discuss their relevance to the
real world:

(a) Modigliani and Miller Irrelevance Theory;

(b) Agency Cost Theory;
(c) Signalling Theory.
(20 marks)

END OF PAPER

© University of London 2017

Page 9 of 11 D0
UL17/0145
PRESENT VALUE TABLE

Present value of $1, that is (1+ r )

Periods Interest rates (r)

 The Chartered Institute of Management Accountants 2010

UL17/0145 Page 10 of 11
Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
1−(1+ r )− n
years r

Periods Interest rates (r)

UL17/0145 Page 11 of 11
Examiners’ commentaries 2017

Examiners’ commentaries 2017

AC3059 Financial management

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of the course and having completed the essential reading and activities, you should be
able to:

• describe how different financial markets function

• estimate the value of different financial instruments (including stocks and bonds)
• make capital budgeting decisions under both certainty and uncertainty
• apply the capital assets pricing model in practical scenarios
• discuss the capital structure theory and dividend policy of a firm
• estimate the value of derivatives and advise management how to use derivatives in risk
management and capital budgeting
• describe and assess how companies manage working capital and short-term financing
• discuss the main motives and implications of mergers and acquisitions
• integrate subject matter studied on related modules and to demonstrate the
multi-disciplinary aspect of practical financial management problems
• use academic theory and research to question established financial theories
• be more proficient in researching materials on the internet and Online Library
• use excel for statistical analysis.

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AC3059 Financial management

Format of the examination

The examination is three hours long, during which you should answer five questions from a selection
of eight. The paper has two sections, A and B, with six questions in Section A and two in Section B.
Candidates should answer four questions from Section A and one from Section B. All questions carry
equal marks.

Section A has the analytical and computational questions that test your ability to apply analytical
and computational skills to the problems set, and then they usually conclude with a part requiring
interpretation of the solutions prepared in the first part(s) of the question. The questions in Section
B usually require a mix of understanding, knowledge, description or analysis and application applied
to the theory, concept or practical scenario presented. The answer should then be presented in an
essay format, unless otherwise requested.

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

Approach to questions set and format of the answers given

The problem-based questions in Section A are quite lengthy and to speed up your understanding
and analysis of what each question is about, we suggest that first you go to the end of each question
and read the requirements for that question before reading the text in the body of the question.
This approach saves you time that otherwise would have been spent reading information for a
question that you are not going to attempt, since you can decide whether or not to attempt a
question once you have read its requirements. If you are not going to attempt a particular question,
then you have not wasted time reading information that you do not need to read.

The second benefit is that, having read the requirements for a question you are going to attempt,
you can then go on and read the whole question with an idea of what information you expect to be
looking for in order to answer the question set.

Wherever a written answer is required, be it a whole answer or just part of the answer, you will be
expected to produce an answer which presents and develops the theory(ies) and concept(s) that are
appropriate, and then to sustain your argument in the context of the question set. If a judgement is
required, then it should be demonstrated in light of the argument you have presented for the context
given to you. The length of your answer should reflect the maximum marks that can be awarded to
your answer. Do not write page after page to answer a question that is only worth, say, five marks
maximum, since you should not spend more than nine minutes on such an answer. If you have spent
more time on the five-mark answer, you are reducing the time you could spend earning marks
elsewhere. Remember that spending more than a quarter of the examination time on one or more
questions can seriously reduce your chances on the other question(s) you want to tackle.

Read widely

You are expected to read beyond the subject guide and the additional material, and any insights you
gain should be included in your answers. For example, you could go beyond the textbook and
subject guide material on the efficient markets hypothesis and read a wide range of articles on
various research studies on semi-strong and weak form markets. You will then have the material you
need to answer a question on efficient markets.

Answer forms

In the answers to the computational questions you should include your workings. Partial credit
cannot be awarded if the final numbers presented are wrong through errors of omission, calculation

2
Examiners’ commentaries 2017

etc. unless your workings are shown.

In the essay-type questions, you should structure your answers, starting with an introductory
paragraph that outlines the answer you will be giving and the arguments you will be making. In the
main body of your answer, describe the theories and concepts that provide the basis of the argument
that can then be developed and substantiated. The concluding section should draw together the
main points of your argument in a summary.

Key steps to improvement

• Read beyond the subject guide.
• Practise computational questions in the subject guide, textbooks and any other appropriate
sources.
• Practise both computational and written questions from past examination papers. As the
examination draws closer, practise under time pressure, remembering that you probably
only have approximately 36 minutes per question in which to write your answer.
• Ensure your written answers to your practice questions do attempt to answer the questions
posed and not the one you wish you could be answering. Learn to focus on the contents,
context and requirements of that specific question.

Readings for this paper

Please note that shorthand will be used when referring to the following textbooks:

• BMA – Brealey, R.A., S.C. Myers and F. Allen, Principles of corporate finance. (New York:
McGraw–Hill Inc, 2010) tenth edition [ISBN 9780071314268].
• SG – subject guide. Fung, L. Financial management. (London: University of London
International Programmes, 2015).

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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AC3059 Financial management

Examiners’ commentaries 2017

AC3059 Financial management

Important note

Information about the subject guide and the Essential reading

references

Comments on specific questions – Zone A

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

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

Section A

Answer FOUR questions from this section.

Question 1

Roland plc manufactures high quality vehicle tyres. It has just won a contract to
supply 80,000 mud track tyres to the car manufacturer, Toyota, for the next eight
years. The company will need to purchase new equipment for this purpose, although
existing factory space with a book value of £6,800,000 will be used as the
manufacturing site, and is evaluating the two options posed below.

Option 1:
The equipment will cost the company £5,600,000, payable immediately. It has a life
of 4 years, and is not expected to generate a resale value at the end of its life.

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Examiners’ commentaries 2017

Costs associated with the manufacture of the tyres using this equipment are as
follows:

Cost per unit (£)

Materials 16
Labour 8
Variable overhead 10

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis)

have been estimated at £2,000,000.

Option 2:
The equipment will cost the company £8,000,000, payable immediately. It has a life
of 8 years, and is estimated to generate a scrap value of £800,000 at the end of its
life.

Costs associated with the manufacture of the tyres using this equipment are as
follows:

Cost per unit (£)

Materials 17
Labour 7
Variable overhead 12

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis)

have been estimated at £3,000,000.

In addition, given the technical advancement of this equipment, the company will
incur training costs worth £200,000 in its first year. This cost will not be repeated
in subsequent years.

For both options, the company will need a working capital investment worth
£1,000,000. This will be recovered at a rate of 90% when the contract with Toyota
comes to an end in 8 years time.

Further, it is company policy to allocate 10% of head office costs to individual

projects. Annual head office costs currently stand at £1,000,000.

Roland plc has a cost of capital of 12%.

REQUIRED:

(a) For the benefit of management at Roland plc, determine which equipment
option will be more cost effective for the company.
(14 marks)

(b) Explain the implications of each of the following on your decision in (a) above
(you are not expected to conduct any further computations):

i. Toyota, Roland plc’s customer, delayed the start of the contract by 12

months;
ii. The equipment in Option 2 did not generate a scrap value; and
iii. Toyota extended the contract for another 8 years.

(6 marks)

Notes: assume all cash flows take place at the end of the year, unless otherwise
stated. Ignore taxation and inflation.

5
AC3059 Financial management

Reading for this question

BMA, Chapters 5 and 6.

SG, Chapters 2, 3 and 4.

Approaching the question

This question addresses issues related to project appraisal, choice of a machine, in a setting in
which the lives of the machines considered are different. Candidates were expected to consider
relevant incremental costs and derive the PV of the incremental costs associated with each
option. In order to deal with differences in economic lives, one could consider equivalent annual
costs. In this question, it is however easier to derive PVs over a period of eight years.

(a) The PV of the incremental costs associated with each project can be found in the following
table:
£ Option 1 Option 2
Outlay 5,600,000 8,000,000
PV Total Cost 3.32m × 3.0373 = 10,084,000 4.98m × 4.9676 = 24,738,846
PV Scrap Value 0.8m × 0.4039 = 323,107
Training Cost 200,000 × 0.8929 = 178,571
PV (4 Yr period) 15,684,000
PV (8 Yr Period) 15,684,000 × (1 + 0.6355) 31,594,311
= 25,651,465

Workings (£) Option 1 Option 2

Variable Cost per Unit 34 36
Total Variable Cost 34* × 80,000 = 2.72m 36 × 80,000 = 2.88
Relevant Fixed Cost 2m − (5.6m/4) = 0.6m 3m − [(8m − 0.8m)/8] = 2.1m
Total Cost 3.32 4.98

Other costs, such as working capital, apply to both machines. There is thus no need to
consider them in order to determine which machine should be purchased.
Option 1 is thus the most attractive option.
(b) With respect to implications of the following on your decision:
i. Not relevant.
ii. Option 2 would still be less attractive.
iii. No change. The costs would rise inevitably but the optimal machine option would
remain.

Question 2

Orian plc reviews its credit policy at regular intervals. Its current policy offers
customers a 60 days credit period with a discount of 2% for all payments settled
within 30 days. 30% of its customers take advantage of the discounting facility and
the remainder pay on average in 70 days. Bad debts currently stand at 3% of annual
sales. The sales forecast for next year is £1,200,000 assuming this credit policy is
maintained.

Two new policy proposals have been put forward by the senior management team.
They are as follows:

Proposal 1
The finance director has called for the policy to be tightened. He believes customers
should be offered a discount of 2% on pay settlement within 10 days and the

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Examiners’ commentaries 2017

remainder should be offered a credit period of 30 days. Only 15% of customers, it

would be expected, would take advantage of the discounting facility and the
remainder of customers would pay on average in 45 days. Bad debt will fall to 2%
and annual sales forecast is not expected to change under this policy. To tighten the
policy, the company would incur costs of £25,000.

Proposal 2
The marketing director takes an opposing view and she suggests that the policy
should be relaxed to attract more customers. She proposes that customers be
offered a 3% discount for all payments settled within 30 days. 40% of customers
would be likely to take advantage of the discounting facility. Policy for the
remainder will be lax and they are likely to pay on average in 90 days. This
proposal is likely to be attractive to the market and the marketing team forecast
sales will rise by 20% if this policy is introduced. They accept it may attract high
risk customers and propose that provision for bad debt be set to 6% of annual sales.

Orian plc earns a contribution of 25% on sales revenue and its cost of capital has
been estimated at 10% per annum.

REQUIRED:

(a) Explain what working capital management refers to and discuss the importance
of a working capital management policy for companies.

(5 marks)

(b) Advise Orian plc, which of the two plans, if either to adopt.

(15 marks)

Reading for this question

BMA, Chapter 30.

SG, Chapter 18.

Approaching the question

This question addresses issues related to working capital management. Candidates were expected
to derive net costs, that is, costs less any incremental contribution, associated with the current
policy and the new policy proposals.

(a) Working capital management refers to a company’s strategy designed to monitor and utilise
the components of working capital to ensure the most financially efficient operation of the
company.

(b) The current policy is the better one as confirmed by the following derivations:

Current Setting Proposal 1 Proposal 2

Bad Debt 3% × £1,200,000 2% × £1,200,000 £1,200,000 × 1.2
= £36,000 = £24,000 =£1,440,000

6% × £1,440,000
= £86,400
Discount 2% × 30% × £1,200,000 2% × 15% × £1,200,000 3% × 40% × £1,440,000
= £7,200 = £3,600 = £17,280

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AC3059 Financial management

Debtor [30% × 30/365 + [15% × 10/365 + [40% × 30/365 +

Investment 67% × 70/365] 83% × 45/365] 54% × 90/365]
× £1,200,000 × £1,200,000 × £1,440,000
= £183,781 = £127,726 = £239,079
£183,781 × 10% £127,726 × 10% £239,079 × 10%
= £18,378 = £12,773 =£23,908
Total Cost So Far £61,578 £40,373 £127,588
Other Cost £25,000
Total Cost £61,578 £65,373 £127,588
Incremental 20% × 25% × £1,200,000 × 94%
Contribution = £56,400
Net Cost £61,578 £65,373 £71,188

Question 3

Angel plc and Cherub plc are two companies that both operate in the brewery
industry. Within the industry, both companies undertake similar activities and
experience the same risk. While Angel plc is an all equity company, Cherub plc is
financed by a combination of debt and equity. Details of their financial structures
and cash flow situations follow.

Cherub plc has 200 million shares with nominal and current market values of £1.00
and £2.40 (ex div.) respectively. The company also has 6% irredeemable debt of
£120 million, currently valued at par. Angel plc, on the other hand, has 400 million
shares, valued at £2.00 (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.

Marissa owns 40,000 shares in Angel 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. Marissa has, however, been told by a friend that she
could generate a better return by changing her investment from Angel plc to
Cherub 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 Cherub plc and Angel plc. Comment on your results.
(8 marks)
(b) Calculate Marissa’s current financial position and show whether, and if so how,
she can improve this financial position by moving her investment from Angel plc
to Cherub plc without changing the risk class of her total holding.
(7 marks)
(c) Briefly explain the effect of transactions you propose in (b) above on the share
prices of Angel plc and Cherub plc and identify two factors that may prevent an
investor like Marissa from moving her investment.
(5 marks)

Reading for this question

BMA, Chapter 9.

SG, Chapters 14 and 15.

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Examiners’ commentaries 2017

Approaching the question

This question addresses issues related to mispricing of firms’ securities when firms are in the
same industry but differ in leverage. In part (a), candidates are expected to compute the cost of
capital for both firms using valuation formulae and the cost of capital for each security using the
fact that the overall cost of capital is the weighted average of the various securities’ cost of
capital. In equilibrium, we would expect both firms to have the same overall cost of capital as
they have the same type of assets. This is, however, not the case in this examination question
which justifies part (b) in which candidates are expected to take advantage of the mispricing. In
part (c), candidates were expected to note that, if many investors were as sophisticated as them,
the pricing anomaly would disappear.

(a) Assuming that capital markets are efficient, the market price of Angel’s shares should be
equal to the present value of the expected dividends per share. Since expected cash flows
per share are constant through time, there is no debt in the firm’s capital structure, and
cash flows per share are distributed as dividends in the year in which they are generated, it
follows that expected dividends per share are constant through time. It follows that
A
pA = E(dpsA )/rE . Equivalently:

A E(dpsA ) £100m/400m
rE = = = 12.5%.
pA £2
As there is no debt in Angel’s capital structure, Angel’s cost of capital, rA , is equal to its
cost of equity capital.
With respect to Cherub, the cost of equity capital can be derived using the method used for
Angel and recognising that part of the cash flows per share are paid out as interest
payments to debtholders. Hence:
C E(dpsC ) £100m − (6% × £120m)
rE = = = 19.3%.
pC 200m × £2.4
C
Cherub’s cost of debt capital, rD , is given to be equal to 6%. It hence follows that Cherub’s
C
cost of capital, r , derived as the weighted cost of equity capital and the cost of debt
capital, is given by the following equality:

C VD C VE C
r = rD + rE
VD + VE VD + VE

£120m 200m × £2.4
= × 6% + × 19.3%
£120m + (200m × £2.4) £120m + (200m × £2.4)
= 0.2 × 6% + 0.8 × 19.3%
= 16.7%.
As Cherub and Angel operate in the same industry, Cherub and Angel should have the same
cost of capital. Hence, Cherub is undervalued compared with Angel.
(b) Marissa’s investment in Angel: 40,000 × £2 = £80,000.
Dividends paid by Angel: £100m.
Marissa’s annual dividends: £100m × 0.04m/400m = £10,000.
So Marissa should sell her shares in Angel (getting proceeds equal to £80,000), lend £80,000
× £120m/£600m = £16,000, and invest £64,000 in Cherub.
Marissa’s investment in Cherub shares would be £64,000 made of £64,000/£2.4 = 26,667
shares.
Marissa’s annual dividends would then be equal to (£100m − (6% × £120m)) ×
26,667/200m = £12,373.
Marissa’s annual interest income would be equal to £16,000 × 6% = £9,600.
Marissa’s annual net income would then be equal to £21,973.
Thus for the same level of her own net investment, and the same risk, Marissa has improved
her position.

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AC3059 Financial management

(c) In equilibrium, we would expect the share price of Cherub to increase or the share price of
Angel to decrease up to the point at which the cost of Angel’s firm capital is equal to the
cost of Cherub’s firm capital. Limits to arbitrage include transaction costs and taxes.

Question 4

Butterfly plc is financed by a combination of debt and equity. The company has
£150m 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 £20 million for a guaranteed cash flow of £40 million at the end of the
financial year. The capital for this investment will have to come from the company’s
equity holders. The firm also has in place other assets that generate some cash
flows. The level of cash flows from these assets is dependent upon the state of the
economy, of which there are 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 0.3 0.4 0.3
Cash flow from assets 90 120 150
already in place (£m)

REQUIRED:

(a) Assuming that the company operates purely in the interests of its current
equity holders, determine whether it should proceed with the project.
(7 marks)
(b) Revisit the position in (a) above if the company’s debt was only £90m.
(3 marks)
(c) Explain: why management may operate in the interests of equity holders rather
than debtholders; the underinvestment problem for firms in the context of
capital structure decisions; and agency problems between debt- and equity
holders; and compare and contrast the decisions in (a) and (b) above.
(10 marks)

Reading for this question

BMA, Chapter 18.

SG, Chapter 12.

Approaching the question

This question addresses issues related to project selection in highly levered firms. Candidates
were asked whether or not a manager operating in the interest of current equity holders would
invest in a positive NPV project depending on the firm’s level of debt. In order to answer this
question, candidates were expected to derive the incremental cash-flows to the current equity
holders generated in each state of nature and compute the net present value of the project to the
current equity holders.

(a) The answer is no as the NPV of the project to the current equity holders is negative.

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Examiners’ commentaries 2017

Let us first derive the incremental cash-flows to the current equity holders generated by the
project:
S1 S2 S3
P 30% 40% 30%
No investment
CFO 90 120 150
CF to Equity Holders 0 0 0
Investment
CFO 90 120 150
Project CF 40 40 40
CF to Equity Holders 0 10 40
Incremental CF to Equity Holders 0 10 40
It follows that:
NPVE = −£20m + [(40% × £10m) + (30% × £40m)] = −£4m.

(b) Let us first derive the incremental cash-flows to the current equity holders generated by the
project with the lower debt:
S1 S2 S3
P 30% 40% 30%
No investment
CFO 90 120 150
CF to Equity Holders 0 30 60
Investment
CFO 90 120 150
Project CF 40 40 40
CF to Equity Holders 40 70 100
Incremental CF to Equity Holders 40 40 40
It follows that:
NPVE = −£20m + £40m = £20m.
The company operating in the interest of its current equity holders should thus now invest
in this project.
(c) Managers are hired and assessed by equity holders as opposed to debt holders. Whenever
one introduces debt in a firm’s capital structure, the set of projects maximising the value of
the firm’s equity differs from the set of projects maximising the value of the firm. This
implies that the set of projects preferred by equity holders differs from the set of projects
preferred by debt holders.
Whenever there is enough debt in a firm’s capital structure, a manager operating in the
interest of the firm’s current equity holders will reject positive NPV projects. This is so
because the current equity holders have to fund 100% of the cost of the project but only
receive benefits in the most favourable states of nature. In part (a), the project could not be
taken. In contrast, in part (b), the project could be taken because the level of debt was
lower.
Candidates could also discuss ways of mitigating the debt overhang (underinvestment)
problem.

Question 5

Answer all parts of this question.

(a) Consider a stock with a current price of $120. This stock is not expected to pay
any dividend over the next three months.
i. What is the price of a 3-month forward contract on this stock assuming that
the risk-free rate over the next three months is 5%?
(7 marks)

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AC3059 Financial management

ii. How would your answer change if the stock was expected to pay $10 of
dividends in three months time just before maturity of the forward contract?
(3 marks)

Reading for this question

BMA, Chapter 26.
SG, Chapter 19.
Approaching the question
This question addresses issues related to the pricing of forwards. Whilst the derivation of
the forward price was not required (application of the relevant formula was good enough),
below provides a proof of the pricing formula using a no-arbitrage condition.
i. Let us consider the following portfolios P1 and P2 constructed as follows:
Portfolios Investment Cost Payoff at Maturity
P1
Forward Contract 0 ST − F
P2
Stock S ST
Borrowing of PV(F ) −PV(F ) −F
S − PV(F ) ST − F
Portfolios P1 and P2 have the same payoff at maturity T . They should thus have the
same investment cost. It hence follows that S − PV(F ) = S − [F/(1 + r)] = 0, where r
denotes the risk-free rate. Equivalently:
F = S(1 + r) = $120 × (1 + 5%) = $126.

ii. Consider again portfolios P1 and P2 constructed as follows:

Portfolios Investment Cost Payoff at Maturity
P1
Forward Contract 0 ST − F
Lending of PV(D) PV(D) D
PV(D) D + ST − F
P2
Stock S D + ST
Borrowing of PV(F ) −PV(F ) −F
S − PV(F ) D + ST − F
Portfolios P1 and P2 have the same payoff at maturity T . They should thus have the
same investment cost. It hence follows that:
F D
S − PV(F ) = S − = PV(D) = .
1+r 1+r
Equivalently:
F = S(1 + r) − D = $120 × (1 + 5%) − $10 = $116.

(b) A non-dividend paying stock is currently priced at £20. In each of the next two
periods, it could either rise in price by 30% or fall in price by 29%. The
one-period interest rate is 10%. A derivative exists that promises a payoff of £5
if, at the end of the second period, the price of the stock is above £16 and
nothing otherwise. Compute the possible price paths of the stock and the
possible payoffs of the derivative, and proceed to price the derivative using the
risk-neutral method.
(10 marks)

Reading for this question

BMA, Chapters 20 and 21.
SG, Chapter 19.

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Examiners’ commentaries 2017

Approaching the question

This question addresses issues related to the pricing of options. Candidates could use the
risk-neutral method to derive the intrinsic price of the option. Solving this question requires
candidates to derive the price of the stock at each possible node at the end of the next two
periods as the option’s payoff at any node depends on the stock price obtained at that node.
Under the risk-neutral method, the current price of the call option is then equal to the
present value of its payoffs obtained at the end of the next two periods using the risk-free
rate to discount the payoffs. The risk-neutral probabilities used to derive the expected
payoff can be obtained by expressing the current price of the stock as the present value of its
payoffs using the risk-free rate to discount the payoffs.
With respect to the binomial setting, the risk-neutral probability q is equal to
(d + r)/(d + u), with u = 30% and d = 29%. Hence q = 66.1%.
If S0 denotes the current stock price, the prices of the stock at the end of the two periods
could be:

SU U = S0 × (1 + u)2 = £20 × (1 + 30%)2 = £33.8

SU D = SDU = S0 × (1 + u) × (1 + d) = £20 × (1 + 30%)(1 − 29%) = £18.5

SDD = S0 × (1 − d)2 = £20 × (1 − 29%)2 = £10.1.

The payoffs to the option are thus:

CU U = £5 with probability q 2

CU D = CDU = £5 with probability 2q(1 − q)

CDD = £0 with probability (1 − q)2 .

The price C0 of the call option now can then be derived as the present value of its payoffs at
the end of the next two periods using the risk-free rate to discount the payoffs:
£5(1 − (1 − q)2 ) £5(1 − (1 − 66.1%)2 )
C0 = = = £4.01.
(1 + r)2 (1 + 5%)2

Question 6

Your company has earnings per share of £4. It has 1 million shares outstanding,
each with a price of £40. You are thinking of buying BoostCo, which has earnings
per share of £2, 1 million shares outstanding, and a price per share of £25. You will
pay for BoostCo by issuing new shares. The synergy as a result of this acquisition
will increase your original companys EPS and share price by 25%.

REQUIRED:

(a) If you do not pay any premium to buy BoostCo, what will your earnings per
share be after the acquisition?
(8 marks)
(b) Assuming instead that you pay a 20% premium to buy BoostCo:
i. What will your earnings per share be after the acquisition?
(3 marks)
ii. Are you better off with this acquisition? Explain.
(3 marks)
(c) What is the maximum percentage premium you are willing to pay before
BoostCo becomes too expensive to acquire?
(6 marks)

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AC3059 Financial management

Reading for this question

BMA, Chapter 31.

SG, Chapter 16.

Approaching the question

This question addresses issues related to mergers and acquisitions. Candidates are expected to
derive the cost and NPV of an acquisition to the shareholders of the acquiring firm when the
acquisition is paid with shares in the combined company. Addressing this issue requires
computing the proportion of shares to be given to the shareholders of the target firm which
should be equal to the ratio of the value of the target firm (including any premium paid) over the
post-acquisition value of the combined firm.

(a) The post-acquisition value of Y is:

VY (1 + s) + VB = 1m × £40 × (1 + 25%) + 1m × £25 = £75m

where:
• VY denotes the pre-acquisition value of your company
• s represents the present value of the synergies divided by the pre-acquisition value of
your company
• VB denotes the value of BoostCo.
As all shares have the same claim, the proportion of shares to be given away to the new
shareholders is hence:
n VB £25m 1
= = =
n+N VY (1 + s) + VB £75m 3
where:
• n denotes the number of new shares to be issued
• N denotes the existing number of shares in your company.
It follows that n = N/2 = 0.5m.
Post-acquisition, the total number of shares in your company will hence be 1.5m.
Post-acquisition, earnings will be 1m × £4 × (1 + 25%) + 1m × £2 = £7m.
Hence EPS will be £7m/1.5m = £4.67.
(b) The proportion of shares to be given away to the new shareholders is now:

n VB (1 + p) £30m
= = = 40%
n+N VY (1 + s) + VB £75m

with p denoting the percentage premium offered.

It follows that n = 2N/3 = 0.67m.
The total number of shares in your company will be 1m × (1+(2/3)) = 1.67m.
Post-acquisition earnings will be unchanged.
Hence EPS will be £7m/1.67m = £4.19, which is lower than before.
Your post-acquisition equity stake in the company will be N/(n + N ) = 60%. You will be
definitely better off with this acquisition as the value of your equity stake will be:

N
(VY (1 + s) + VB ) = 60% × £75m = £45m
n+N
which strictly exceeds the current equity value of £40m.

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Examiners’ commentaries 2017

(c) The maximum percentage premium you should be willing to pay before BoostCo becomes
too expensive to acquire should leave you with a zero NPV investment. This will happen
when you give away the present value of the synergies, VY × s, to the shareholders of
BoostCo, that is, when the premium paid to them, VB × p, is equal to the present value of
the synergies, VY × s. The percentage premium paid p is hence given by the following
equation:
VY × s £40m × 25%
p= = = 40%.
VB £25m

Section B

Answer ONE question from this section.

Question 7

Describe and critically evaluate the use of financial ratios to assess the leverage of a
publicly quoted company.

(20 marks)

Reading for this question

BMA, Chapter 28.

SG, Chapter 17.

Approaching the question

This question is designed to test candidates’ understanding of financial analysis. The answers to
all parts of this question were provided in the subject guide.

A good quality answer to this question should not just describe a number of financial ratios
which the candidate thinks are appropriate but should also lay the foundations by identifying the
general limitations of ratio analysis and what implications they may have when trying to assess
the ratios being used to measure a company’s leverage. There are quite a number of limitations
and a candidate is expected to know the majority. The limitations include such points as the fact
that the accounting numbers are historical and may well be out of date; that there are some
differences in accounting definitions and techniques in principle as well as between companies;
there are differences over time due to changes in both the economic and reporting environments;
one may not have appropriate standards for comparison, particularly bearing in mind that
short-run fluctuations may be hidden and that the numbers from a balance sheet only reflect
that one datum point. Accounts are published documents and so their authors may want to
include some window dressing, or be economical in their notes to the accounts which can
exacerbate an analyst’s problems particularly when reviewing the accounts of a diversified
company. A final point worth making is that the past as reflected in the accounts may not be a
good predictor of the future.

Question 8

Critically assess the following theories of dividend policy and discuss their relevance
to the real world:

(a) Modigliani and Miller Irrelevance Theory;

(b) Agency Cost Theory;
(c) Dividend Clientele Theory.

(20 marks)

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AC3059 Financial management

Reading for this question

BMA, Chapter 16.

SG, Chapter 13.

Approaching the question

This question was designed to test candidates’ understanding of dividend policy. Candidates
were expected to provide the assumptions behind each theory, implications for dividend policy, as
well as empirical evidence on dividend policy. The answers to all parts of this question were
provided in the subject guide.

A rather surprisingly large number of candidates ended up discussing capital structure. No

marks were provided in this instance.

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Examiners’ commentaries 2017

AC3059 Financial management

Important note

Information about the subject guide and the Essential reading

references

Comments on specific questions – Zone B

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

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

Section A

Answer FOUR questions from this section.

Question 1

Orland plc manufactures high quality vehicle tyres. It has just won a contract to
supply 80,000 mud track tyres to the car manufacturer, Toyota, for the next eight
years. The company will need to purchase new equipment for this purpose, although
existing factory space, with a book value of £6,800,000, will be used as the
manufacturing site and is evaluating the two options posed below.

Option 1:
The equipment will cost the company £5,200,000, payable immediately. It has a life
of 4 years, and an estimated scrap value at the end of this period of £800,000.

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AC3059 Financial management

Costs associated with the manufacture of the tyres using this equipment are as
follows:

Cost per unit (£)

Materials 14
Labour 8
Variable overhead 9

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis)

have been estimated at £2,000,000.

Option 2:
The equipment will cost the company £8,800,000, payable immediately. It has a life
of 8 years, and is not expected to generate a scrap value at the end of its life.

Costs associated with the manufacture of the tyres using this equipment are as
follows:

Cost per unit (£)

Materials 14
Labour 6
Variable overhead 12

Annual fixed costs (inclusive of depreciation, calculated on a straight line basis)

have been estimated at £3,000,000.

In addition, given the technical advancement of this equipment, the company will
incur training costs worth £400,000 in its first year. This cost will not be repeated
in subsequent years.

For both options, the company will need a working capital investment worth
£1,000,000. This will be recovered at a rate of 90% when the contract with Toyota
comes to an end in 8 years time.

Further, it is company policy to allocate 10% of head office costs to individual

projects. Annual head office costs currently stand at £1,000,000.

Orland plc has a cost of capital of 12%.

REQUIRED:

(a) For the benefit of management at Orland plc, determine which equipment
option will be more cost effective for the company.
(14 marks)
(b) Explain the implications of each of the following on yourdecision in a. above
(you are not expected to conduct any further computations):
i. Head office costs were to rise to £1,200,000 as a result of this new contract;
ii. The equipment in Option 1 did not generate a scrap value; and
iii. Toyota, the customer was to extend the contract for another 8 years.
(6 marks)

Note: assume all cash flows take place at the end of the year, unless otherwise
stated. Ignore taxation and inflation.

Reading for this question

BMA, Chapters 5 and 6.

SG, Chapters 2, 3, and 4.

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Examiners’ commentaries 2017

Approaching the question

This question addresses issues related to project appraisal, choice of a machine, in a setting in
which the lives of the machines considered are different. Candidates were expected to consider
relevant incremental costs and derive the PV of the incremental costs associated with each
option. In order to deal with differences in economic lives, one could consider equivalent annual
costs. In this question, it is, however, easier to derive PVs over a period of eight years.

(a) The PV of the incremental costs associated with each project can be found in the following
table:
£ Machine 1 Machine 2
Outlay 5,200,000 8,800,000
PV Total Cost 3.38m × 3.0373 = 10,266,240 4.46m × 4.9676 = 22,155,673
PV Scrap Value 0.8m × 0.6355 = 508,414
Training Cost 400,000 × 0.8929 = 357,143
PV (4 Yr period) 14,957,826
PV (8 Yr Period) 14,957,826 × (1+0.6355) = 31,312,816
24,463,795

Workings (£) Machine 1 Machine 2

Variable Cost per Unit 31 32
Total Variable Cost 31 × 80,000 = 2.48m 32 × 80,000 = 2.56
Relevant Fixed Cost 2m −[(5.2m − 0.8m)/4] = 0.9m 3m − (8.8m/8) = 1.9m
Total Cost 3.38 4.46

Other costs, such as working capital, apply to both machines. There is thus no need to
consider them in order to determine which machine should be purchased.

(b) With respect to implications of the following on your decision:

i. Not relevant.
ii. Machine 1 would be less attractive but still the better option.
iii. No change. The costs would raise inevitably but the optimal machine option would
remain.

Question 2

Orio plc is an all equity company (worth £80 million) that operates in the brewery
industry. It is considering diversifying its business activities into the food and
beverage industry through the acquisition of Chai Ltd. The company expects to
generate synergistic benefits of £2.5 million per annum into perpetuity and hopes to
secure the acquisition at a net price of £20 million, payable immediately.

The finance director has compiled the following information about Orio plc to
enable management to evaluate the worthiness of the acquisition. The current beta
of Orio plc is 1.2 and the risk free rate of interest and the return on the market
portfolio are 2% and 12%, respectively.

A trainee in the finance department believes that it is inappropriate to use the

details of Orio plc to evaluate the acquisition of Chai Ltd. She has gathered the
following information about Coffi-Foud plc, a company that operates in the food and
beverage industry. Coffi-Foud plc is financed by a combination of debt (40%) and
equity (60%) and has a debt and equity beta of 0.2 and 1.2, respectively.

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AC3059 Financial management

REQUIRED:

(a) Explain the benefit of corporate diversification for investors.

(4 marks)
(b) Calculate the cost of capital at Orio plc using the information compiled by the
finance director and evaluate the worthiness of the acquisition of Chai Ltd.
using this information.
(6 marks)
(c) Evaluate the worthiness of the acquisition of Chai Ltd using the information
compiled by the trainee.
(6 marks)
(d) Comment on the views of the finance director and trainee, specifying whose
view you support.
(4 marks)

Note: assume all cash flows take place at the end of the year, unless otherwise
stated. Ignore taxation and inflation.

Reading for this question

BMA, Chapters 9 and 31.

SG, Chapters 14 and 16.

Approaching the question

This question addresses issues related to the determination of the appropriate cost of capital to
be used in the context of an acquisition. Candidates are expected to derive the cost of capital
using two different methods and select the appropriate one.

(a) It is not encouraged as investors can diversify better for themselves. However, at an
individual corporate level and in turn investors’ level, diversification reduces the chances of
bankruptcy provided management are competent to deal in different industries.
(b) Cost of capital of Orio: 2% + 1.2 (12% − 2%) = 14%.
PV of synergistic benefits: £2.5m/14% = £17.86m.
Less cost: 20m = -2.14m
Not worth it.
(c) Asset beta of proxy firm: 0.4 × 0.2 + 0.6 × 1.2 = 0.8.
Cost of capital: 2% + 0.8 (12% − 2%) = 10%.
PV of synergistic benefits:£2.5m/10% = £25m.
Less cost: 20m = 5m.
Acquisition worth it.
(d) The trainee is accurate – the returns required are based on the risk profile of the investment
and given that Orio is moving into another industry, the riskiness of this new industry
becomes more relevant. In other words, brewery and food and average carry different risks
and investors will want compensation with different results.

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Examiners’ commentaries 2017

Question 3

Natalia Batteries develops rechargeable batteries for electric vehicles, including an

industry-leading lithium-ion product in production. Natalia is also pursuing a
project to develop a long-lasting lithium-sulphur version of their product. Though
lithium-sulphur batteries hold four times more energy per mass than lithium-ion
batteries, current lithium-sulphur batteries have relatively shorter lifespans because
they cannot be charged as many times as lithium-ion batteries.

Natalia requires an injection of £80m of outside equity capital to invest in the

project as no bank will finance such a risky project. The following table details the
outcomes linked to the four possible states of the world relevant to Natalia’s
prospects:

Values in millions of £ State 1 State 2 State 3 State 4

Probabilities 25% 25% 25% 25%
Lithium-Ion Assets 200 200 1160 1160
(Assets in Place)
Investment Cost 80 80 80 80
(Lithium-Sulphur)
NPV 10 30 20 100
(Lithium-Sulphur)

When answering this question, state any additional assumptions you may need to
make. Show your calculations.

REQUIRED:

(a) If Natalia’s managers must issue equity without knowing the state of the world,
what percentage of the firm must original equity holders give up in exchange for
the capital?
(6 marks)
(b) Now assume that management knows the true state of the world before the
decision to issue and invest is made. If management is maximising the wealth of
old shareholders and can sell equity at the terms described in part (a), do they
have incentives to use their inside information when deciding whether to issue
equity and invest? Explain.
(4 marks)
(c) Following the argument developed in part (b), explain in which states managers,
knowing the true state of the world and maximising the wealth of old
shareholders, elect not to invest in the lithium-sulphur project.
(10 marks)

Reading for this question

BMA, Chapter 18.

SG, Chapters 12.

Approaching the question

This question addresses issues related to incentives to issue equity in markets in which investors
find it difficult to assess the quality of a firm’s assets in place and NPV of projects. Candidates
are first expected to derive the proportion of the firm’s capital which the existing equity holders
must give up in exchange for receiving capital from the new shareholders. In equilibrium, this
proportion must be equal to the ratio of capital provided over the value of equity following the
issue of capital. Given the proportion of equity given away to new shareholders, candidates are

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AC3059 Financial management

expected to identify the states of nature in which a manager knowing the true state of the world
and maximising the wealth of the existing equity holders elects not to invest in the project. In
order to do so, one needs to compare the intrinsic equity value of the existing equity holders post
investment with the intrinsic value of equity in the absence of any investment.

(a) With respect to ex-post equity values in each state of nature:

VS1 = £200m + £80m + £10m = £290m

VS2 = £200m + £80m + £30m = £310m

VS3 = £1,160m + £80m + £20m = £1,260m

VS4 = £1,160m + £80m + £100m = £1,340m.

It hence follows that the ex-post expected value, VP ost , is given by the following formula:
VS1 + VS2 + VS3 + VS4 £290m + £310m + £1,260m + £1,340m
VP ost = = = £800m.
4 4
The equity stake that has to be given away by the existing shareholders is thus
£80m/£800m = 10%.
(b) There are incentives not to invest if the equity is undervalued enough even though the
project has a strictly positive NPV and incentives to invest if the equity is not too
undervalued.
(c) There is investment in:
• state S1 as 90% × £290m = £261m > £200m
• state S2 as 90% × £310m = £270m > £200m
• state S4 as 90% × £1,340m = £1,206m > £1,160m.
There is no investment in state S3 as 90% × £1,260m = £1,134m < £1,160m.

Question 4

Answer all parts of this question:

(a) Consider two firms with identical required returns of 10% per annum. Firm A
has expected earnings of £5 per share over the next year and for every
subsequent year and commits to paying out all of those earnings as dividends.
Firm B has identical expected earnings to firm A in the next financial year but
commits to a policy whereby it always ploughs back 10% of earnings into
investment projects. The remaining earnings are paid out as dividends. Its
return on equity is 20%.
i. Compute the market values of the two firms and the implied present value of
growth opportunities for firm B.
(8 marks)
ii. Explain the source of the difference in the values of the two firms with
reference to the underlying data.
(2 marks)

Reading for this question

BMA, Chapter 19.
SG, Chapter 15.
Approaching the question
This question addresses issues related to the impact of dividend policy on a firm’s valuation.
Candidate are expected to value firms on the basis of growing perpetuities of cash flows,
with the growth rate being equal to the product of the plowback ratio (one minus the
payout ratio) and return of equity.

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Examiners’ commentaries 2017

i. We have:
E(DIVA ) £5m
VA = = = £50m
rE 10%
and:
E(DIVB )
VB =
rE − gB
with:

P Y RB = 1 − 10% = 90% highlighted in yellow

E(DIVB ) = E(N PB ) × P Y RB = £5m × 90% = £4.5m

gB = (1 − P Y RB ) × ROE = 10% × 20% = 2%.

It hence follows that:

£4.5m
VB = = £56.25m.
10% − 2%
The implied present value of growth opportunities for firm B is thus VB − VA = £6.25m.
ii. The difference in the values comes from the higher present value of expected dividends
associated with firm B compared with firm A. The extra investment made by firm B
generates value for its shareholders as the ROE associated with this extra investment
exceeds the 10% required return.

(b) An investor has access to a set of N securities with N being very large. Each of
them has an annual return variance of 25% and the correlation between every
pair of the N assets is 50%. The investor wishes to build an equally weighted
portfolio of these N assets that has a return variance of 15% or smaller. What
is the smallest number of assets that this portfolio should contain?
(10 marks)

Reading for this question

BMA, Chapter 8.

SG, Chapter 6.

Approaching the question

This question addresses issues related to the effect of diversification on the variance of a
portfolio. Candidates are expected to write the general formula for the variance of a portfolio’s
returns when the portfolio is invested in N securities and customize it to a setting in which all
weights are equal distinguishing between the variance and covariance terms. Candidates are then
expected to solve the equation for the number of securities the portfolio should be invested in to
reach the threshold variance.

The variance of the portfolio can be written as follows:

2 N 2 N (N − 1) 2
σN = σ + ρσ .
N2 N2
Equivalently:
σ 2 (1 − ρ) 25% × 50%
N= 2 − ρσ 2 = 15% − 12.5% = 5.
σN

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AC3059 Financial management

Question 5

Answer all parts of this question:

(a) Julien plc, a UK based company has bought equipment worth $3 million from a
US based company. Payment is to be settled in three months’ time. The
managing director is worried about the uncertainty and potential volatility of
the £–US$ exchange rate (currently £1 : $1.22).
The finance director has suggested the company use a foreign currency option
to hedge this risk. He has negotiated an over the counter option with an
exercise price of £1 : $1.24 and a premium of 0.1% on the dollar value.
i. Assuming that the three month spot rate materialises as £1 : $1.25,
determine the outcome of the hedge.
(4 marks)
ii. Assuming that the three month spot rate materialises as £1 : $1.21,
determine the outcome of the hedge.
(4 marks)

Reading for this question

BMA, Chapters 20 and 21.
SG, Chapters 26 and 27.
Approaching the question
This question addresses issues related to the use of foreign currency options. Candidates are
expected to decide whether or not the currency option should be exercised and derive
payoffs.
i. The currency option should not be exercised as the exercise price is unfavourable. The
net cost to the firm in £ is 3m/1.25 = 2.4m + premium, with the premium being equal
to (0.1% × 3m/1.22) = 2,459.
ii. The currency option should be exercised as the exercise price is favourable. The net cost
to the firm in £ is 3m/1.24 = 2.419m + premium, with the premium being equal to
(0.1% × 3m/1.22) = 2,459.

(b) Assume a one-period binomial setting for stock Z. This stock currently sells for
£20. Over the next period, its price will either rise to £26 or fall to £16. The
one period interest rate is 10%. A one-period call option with strike price £23
exists. It is currently selling in the market for £1.50.
i. Show that this call option is mispriced. Compute the size of the mispricing.
(8 marks)
ii. Devise and explain in detail an arbitrage strategy that generates risk-less
profits from this mispricing. Compute the instantaneous profits from the
arbitrage strategy.
(4 marks)

Reading for this question

BMA, Chapters 20 and 21.
SG, Chapter 19.
Approaching the question
This question addresses issues related to the pricing of options. Candidates could use either
the risk-neutral method or the portfolio replicating method in order to derive the intrinsic
price of the call option. Candidates should then compare the market value of the option with
its intrinsic price and compute the size of any mispricing. In order to exploit any mispricing,
one could take positions in both the call option and the portfolio replicating the call option.

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Examiners’ commentaries 2017

With respect to the binomial setting:

i. The risk-neutral probability q is equal to (d + r)/(d + u), with
u = (£26/£20) − 1 = 30%, d = −(£16/£20) + 1 = 20%. Hence q = 60%.
The fundamental price of the call option is:

q ((1 + u)S − X)
= £1.64.
1+r
The option mispricing is thus £1.64 − £1.50 = £0.14.
ii. As the call option is overvalued, investors could buy the call option’s replicating portfolio
and short-sell the call option.

Question 6

Consider a risk-neutral entrepreneur who has two investment opportunities. Both

require an investment of £100m upfront with the following payoffs in the next year:

A pays £200m with probability 40% and £0m with probability 60%; B pays £120m
for sure.

The risk-free rate is normalised to 0% for your computational convenience.

REQUIRED:

(a) If the entrepreneur has £100m in cash to fund the investment, which project
will he choose? Show your calculations.
(4 marks)
(b) Now suppose that the entrepreneur has no cash and must issue straight debt
with one year maturity to raise the required investment of £100m. If the
entrepreneur can commit to take project B, what is the required face value of
debt such that the market value of debt is £100m?
(4 marks)
(c) Assume that the entrepreneur convinces debtholders that he will take project B
even though no commitment is possible. After the debt is in place, which
project will the entrepreneur choose? Show your calculations.
(6 marks)
(d) If you were a sophisticated bank, anticipating the entrepreneur’s choice of
investment after taking the loan, would you make the loan at any face value? If
not, why? If so, at what face value can you break even?
(6 marks)

Reading for this question

BMA, Chapter18.

SG, Chapter 12.

Approaching the question

This question addresses issues related to the agency cost of risk shifting. In part (a), candidates
were expected to derive the net present value associated with each project and identify on this
basis the project selected by the entrepreneur. In part (b), candidates were expected to derive
the promised repayment of debt assuming that the market for borrowing and lending was very
competitive. In such a market, the amount lent must be equal to the present value of the
repayments. In part (c), candidates were expected to derive the value of equity associated with

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AC3059 Financial management

each project and conclude that the entrepreneur would engage in asset substitution by investing
in project A. In part (d), candidates were expected to assume that a sophisticated banker would
expect the entrepreneur to invest in project A after borrowing the funds and hence choose an
appropriate debt repayment for project A.

(a) Let us derive the net present value of each investment:

NPVA = −£100m + (40% × £200m) = −£20m

NPVB = −£100m + £120m = £20m.

Alternatively, we could also derive the value of equity as of the investment date associated
with each project:

VEA = (40% × £200m) = £80m

VEB = £120m.

An entrepreneur with £100m of cash would thus select project B.

(b) If the entrepreneur can commit to taking project B, the loan is risk free and thus the face
value F of debt (promised debt repayment) is £100m.
(c) Let us derive the value of equity as of the investment date associated with each project:

VEA = 40% × (£200m − £100m) = £40m

VEB = £120m − £100m = £20m.

An entrepreneur having issued £100m of debt would thus select project A after having
promised to select project B.
(d) Let us assume that the face value of debt is lower than £200m. If the banker anticipates
that project A will be selected, in a competitive banking market, the funds lent must be
equal to the expected debt repayment to the banker when project A is selected:

£100m = 40% × F

and hence F = £250m. This offer is, however, rejected by the entrepreneur as the cash flow
generated is strictly lower than £250m regardless of the state of nature.

Section B

Answer ONE question from this section.

Question 7

Describe and critically evaluate the use of financial ratios to assess the liquidity of a
publicly quoted company.

(20 marks)

Reading for this question

BMA, Chapter 28.

SG, Chapter 17.

Approaching the question

This question is designed to test candidates’ understanding of dividend policy. The answers to all
parts of this question were provided in the subject guide.

26
Examiners’ commentaries 2017

A good quality answer to this question should not just describe a number of financial ratios
which the candidate thinks are appropriate but should also lay the foundations by identifying the
general limitations of ratio analysis and what implications they may have when trying to assess
the ratios being used to measure a company’s liquidity. There are quite a number of limitations
and a candidate is expected to know the majority. The limitations include such points as the fact
that the accounting numbers are historical and may well be out of date; that there are some
differences in accounting definitions and techniques in principle as well as between companies;
there are differences over time due to changes in both the economic and reporting environments;
one may not have appropriate standards for comparison, particularly bearing in mind that
short-run fluctuations may be hidden and that the numbers from a balance sheet only reflect
that one datum point. Accounts are published documents and so their authors may want to
include some window dressing, or be economical in their notes to the accounts which can
exacerbate an analyst’s problems particularly when reviewing the accounts of a diversified
company. A final point worth making is that the past as reflected in the accounts may not be a
good predictor of the future.

Question 8

Critically assess the following theories of dividend policy and discuss their relevance
to the real world:

(a) Modigliani and Miller Irrelevance Theory;

(b) Agency Cost Theory;
(c) Signalling Theory.

(20 marks)

Reading for this question

BMA, Chapter 16.

SG, Chapter 13.

Approaching the question

A rather surprisingly large number of candidates ended up discussing capital structure. No

marks were provided in this instance.

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