Ac.F263 INTRODUCTION TO FINANCE

QUESTION 1

ANSWER ALL PARTS OF THIS QUESTION

a.    GetFair plc is not expected to pay dividends in the next four years. In year 5, it is expected to pay a dividend of £3 per share. Dividends are expected to be maintained at this level for the foreseeable future thereafter. Assume investors require a return of 8 per cent. What is each of GetFair shares currently worth?

[6 marks]

b.    Macrosoftware plc is a young start-up company. No dividends will be paid on its stock over the next 7 years because the firm intends to reinvest all its earnings to generate growth. The company will then pay a £1 per share dividend in year 8 and will increase the dividend by 4 per cent per year thereafter. If the required return on this stock is 9 per cent, what is the current share price?

[8 marks]

c.    Castlebank plc is trading at £51.25 per share. The stock currently pays a dividend of £2.50 per share. Assuming that the expected growth in dividends will be 5% a year forever,        estimate the return that you can expect to make as an equity investor in this stock.

[6 marks]

d.   What is the value of a share in a company that currently pays out £1.00 per share in dividends and expects these dividends to grow at 15 per cent a year for the next 5 years and 6 per cent a year forever after that? (You should assume that investors require 12.5 per cent return on stocks of equivalent risk.)

[10 marks]

e.    Compare and contrast the characteristics of common stocks and preferred stocks.

[10 marks]

f.     Briefly explain the dividend discount model used for the valuation of common stocks.

[5 marks]

Discuss the limitations of the Gordon Growth model for the valuation of stocks.

[5 marks]

TOTAL 50 MARKS

QUESTION 2

ANSWER ALL PARTS OF THIS QUESTION

a.    You have valued a British consol (perpetual bond) at £636. Assuming that the coupons are paid semi-annually and that the interest rate on risk-free government bonds is 6% per annum, estimate the annual coupon on this bond.

[3 marks]

b.   You buy a 10-year zero-coupon bond, with a face value of £1,000, for £300. What rate of return will you make on this bond, assuming you hold it until maturity?

[5 marks]

c.    What is the value of a 15-year corporate bond, with the coupon rate of 9%, if current interest rates on similar bonds are 8%?

[8 marks]

d.   You take out a three-year loan for £15,000. The loan requires equal annual payments and the interest rate is 10 per cent.

REQUIRED:

i.     Calculate the equal annual payment required.

[5 marks]

ii.    Prepare an amortisation schedule for the loan repayments. How much interest will you pay in total over the life of the loan?

[10 marks]

e.    Explain interest rate risk and how it affects bonds.

[7 marks]

f.    Compare and contrast the valuation of common stocks with corporate bonds.

[12 marks]

TOTAL 50 MARKS

SECTION B

SECTION B CONSISTS OF QUESTIONS 3 AND 4.

ANSWER ONLY ONE QUESTION FROM SECTION B (EITHER QUESTION 3 OR QUESTION 4).

QUESTION 3

ANSWER ALL PARTS OF THIS QUESTION

a.    Happy Birds plc is considering investing into a new 5-year project after a feasibility research that cost the company £50,000 last month. Based on the research, the project is estimated to generate £600,000 in annual sales with costs of goods sold of £200,000. In addition to this variable cost, there are relevant general & administration expenses of £20,000 each year for the project. This project requires an initial capital spending on a machine that costs £1 million immediately and the company’s accounting department suggests that it is appropriate to depreciate this machine in a straight line over its five-year life to a zero salvage value for accounting and tax  purpose. £25,000 working capital  is  required at the  beginning of the project and the full amount of working capital will be recovered when the project terminates. Given the risk of the project, the appropriate cost of capital is 15% and the company pays a corporate income tax of 40%.

REQUIRED:

i.       What are the project’s free cash flows?

[15 marks]

ii.       Calculate the NPV of this new project and briefly explain the implications of the NPV calculated for the firm’s shareholders.

[10 marks]

iii.       Briefly discuss any potential drawbacks to the NPV method.

[5 marks]

iv.       Calculate the payback period of this new project.

[5 marks]

v.       Briefly discuss any potential shortcomings of the payback period rule.

[5 marks]

b.    Discuss  the  advantages  and  disadvantages  of  Average  Accounting  Return  (AAR)  as  an investment criteria.

[10 marks]

TOTAL 50 MARKS

QUESTION 4

ANSWER ALL PARTS OF THIS QUESTION

a.    Suppose that the market estimates that Stock A and B have the following expected returns under five different states of economy, with their corresponding likelihoods.

REQUIRED:

i.    Calculate the expected return and standard deviation of the two assets.

[10 marks]

ii.       Calculate the expected return and standard deviation of a portfolio consist of 40% in Stock A and 60% in Stock B.

[5 marks]

iii.       Briefly explain why the above portfolio has lower risk than the individual stocks used to construct the portfolio.

[5 marks]

b.   Anaconda Inc has a beta of 0.8 and an expected return of 15% while Python Corp has a beta of 1.2 and has an expected return of 20%. Assume that the CAPM holds and these assets are correctly priced according to their risk.

REQUIRED:

i.       Based on CAPM, what is the expected market return?

[10 marks]

ii.       Suppose that a portfolio that consists of Anaconda Inc and Python Corp with equal weights has an expected return of 17%. Is this portfolio over-priced or under-priced? What will happen to this portfolio in the presence of this mis-pricing?

[5 marks]

c.    Rain Droplets Technologies, a leading social media company, has just paid a dividend of £5 per share. The company’s equity is valued at £60 per share based on a forecast that the company’s dividends will increase at a constant rate of 5%. Suppose that Rain Droplets has a debt-to- equity ratio of 0.8 and its pre-tax cost of debt is 8%. The company pays corporate tax at 40%.

REQUIRED:

i.    Determine Rain Droplets’ cost of equity using the dividend growth model.

[5 marks]

ii.    Briefly discuss the potential drawbacks of the dividend growth model.

[5 marks]

iii.    Calculate the company’s weighted average cost of capital (WACC).

[5 marks]

TOTAL 50 MARKS