The University of Nottingham s5

N1A118-E1 The University of Nottingham

BUSINESS SCHOOL

A LEVEL 2 MODULE, AUTUMN SEMESTER 2006-2007

INTRODUCTION TO FINANCE

Time allowed TWO hours

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Candidates must NOT start writing their answers until told to do so

Section A Consists of 20 Multiple Choice Questions (MCQ). Use the special answer sheet provided to mark your answer. 2.5 marks are given for each correct answer. No marks and no penalty are given for an incorrect answer or failing to answer a particular question.

Answer TWO Questions in Section B. Questions in Section B are worth 25 marks each.

Only silent, self contained calculators with a Single-Line Display or Dual-Line Display are permitted in this examination.

Dictionaries are not allowed with one exception. Those whose first language is not English may use a standard translation dictionary to translate between that language and English provided that neither language is the subject of this examination. Subject specific translation dictionaries are not permitted.

No electronic devices capable of storing and retrieving text, including electronic dictionaries, may be used.

DO NOT turn examination paper over until instructed to do so

ADDITIONAL MATERIAL: Multiple Choice Answer Sheet Present Value Tables Annuity Tables Formula Sheet

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SECTION A

ALL questions in this section are compulsory.

This section consists of 20 Multiple Choice Questions (MCQ). Use the special answer sheet provided to mark your answer. 2.5 marks are given for each correct answer. No marks and no penalty are given for an incorrect answer or failing to answer a particular question.

1. Which of the following business goals is usually accepted as being the most likely to produce a successful business:

(a) Long-term stability (b) Growth (c) Profit maximisation (d) Shareholder wealth maximisation

2. The Separation Theorem (Hirsleifer 1958) is about separating two decisions. Assuming the conditions of the theorem hold which two decisions are separated?

(a) financing decision and dividend decision (b) financing decision and investment decision (c) investment decisions and dividend decision (d) capital structure decision and dividend decision

3. If I want to know how the value of a business has been affected over a year by trading events such as turnover and expenses I should look at:

(a) the balance sheet (b) the cash flow statement (c) the profit and loss account (income statement) (d) elsewhere

4. Which accounting ratio shows what is left of the sales revenue over a period of time after all running expenses for the business in the same period have been paid:

(a) Net profit margin (b) Gross profit margin (c) Price to earnings ratio (d) Return on net assets

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5. Here is a simplified part of some financial statements for a business

Profit and Loss Account Sales: £1,105,000 Cost of sales: £560,000 Expenses (wages, admin, depreciation, etc.): £350,000 Interest: £75,000 Tax: £36,000

Balance Sheet Total assets less current liabilities: £900,000

What is the ROCE (Return on capital employed also known as the return on net assets)?

(a) 13.3% (b) 9.3% (c) 60.6% (d) 21.7%

6. Which one of the following correctly lists securities of the same firm in order of their risk to investors (least risky first, most risky last)?

(i) Preference shares (ii) Bonds (iii) Ordinary shares

(a) Bonds, Preference shares, Ordinary shares (b) Bonds, Ordinary shares, Preference shares (c) Preference shares, Bonds, Ordinary shares (d) Ordinary shares, Preference shares, Bonds

7. The net present value of a particular investment project represents:

(a) The rate of return that the project will earn for the investing firm. (b) The discounted value of the inflows from the project. (c) The present investment required to undertake the project. (d) The increase or decrease in wealth that the project will generate for the investing firm.

8. Hamilton Ltd is assessing an investment project called Project Waikato that will involve an initial outlay and will result in the receipt of perpetual annual cash flows, receivable at the end of each year, of £2.4 million. These cash inflows have a present value of £18 million. This will give a positive net present value of the project of £2 million. What are the net initial outlay and the internal rate of return of Project Waikato?

Initial Outlay (£m) IRR (%) (a) 16 15 (b) 16 12 (c) 20 15 (d) 20 12

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9. A one year project requires an investment now of £100,000 and in one year will have a value of £120,000 with a probability of 0.3 otherwise it will have a value of £92,000. Using a discount rate of 8% what is the expected NPV of this project?

(a) £7037 (b) -£7037 (c) £11,111 (d) -£640

10. A company has a production line that it intends to run for the foreseeable future. As part of this system it needs a specialised machine. The machine has an initial cost of £100,000 and maintenance costs are £20,000 per year, paid at the end of each year. The machine must be replaced every 5 years when it has a scrap value of zero.

Ignoring any capital allowances what is the equivalent annualised cost using a discount rate of 10%?

(a) £26,380 (b) £46,380 (c) £40,000 (d) £52,760

11. The required rate of return on a government project, assuming no inflation, is 6%. If the estimated cash flows are expressed in nominal (money) terms, what discount rate should be applied to those cash flows to discover the net present value, assuming an inflation rate of 3% throughout the period of the project?

(a) 2.91% (b) 3.00% (c) 9.00% (d) 9.18%.

12. Specific risks relating to an investment may best be described as

(a) Particular macro-economic risks such as changes in interest rates. (b) Any risk that might affect both the particular investment and most other investments as well. (c) Those risks that relate to the particular investment, but not to most other investments. (d) Those risks whose effects cannot be diversified away.

13. The only circumstances where diversification of investments is not beneficial in terms of risk reduction is where investments

(a) Have zero correlation. (b) Are negatively correlated but less than perfectly so. (c) Are positively correlated but less than perfectly so. (d) Are perfectly positively correlated.

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14. Four investments have the following characteristics for the expected return and the standard deviation of the returns:

Expectation (%) Standard deviation (%) Investment A 15 20 Investment B 10 18 Investment C 25 20 Investment D 20 24

Using the expected value criterion (also known as the mean/variance criterion) Which of the following statements is true?

(a) Choose A in preference to B and choose C in preference to D (b) Choose B in preference to A and choose C in preference to A (c) Choose D in preference to A and choose C in preference to B (d) Choose C in preference to A and choose C in preference to D

15. I invest £1000 in a company with a CAPM beta of 1.4 and £2000 in a company with a CAPM beta of 0.8. The beta of my portfolio is:

(a) 1.0 (b) 0.9 (c) 1.2 (d) 1.4

16. An efficient capital market is one where

(a) Transactions are cheaply and efficiently carried out. (b) Security prices show smooth patterns of movement. (c) Security prices do not reflect all relevant information. (d) Security prices always rationally reflect all relevant information.

17. An investor, who makes investments in shares on the basis of her analysis of firms’ annual reports, must believe that the relevant stock market is

(a) not strong form efficient. (b) not semi-strong form efficient. (c) not weak form efficient. (d) not efficient at any level.

18. The reason for using the services of an underwriter, when making a public issue of ordinary shares, is

(a) to keep issue costs to a minimum. (b) to try to make sure that the shares are issued at the highest possible price. (c) to avoid the possibility that not all of the shares on offer will be taken up. (d) to avoid having to supply confidential information to the public.

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19. I have a share which a year ago cost me £2.50. Its price is now is £2.60. It has just paid a cash dividend of 35p. Which of the following best gives the return on the share over the past year?

(a) 14% (b) 4% (c) 18% (d) 17%

20. How do you assess the following two statements?

(1) Every change in the market price of a loan stock affects its coupon rate.

(2) Every change in the market price of a loan stock affects its yield.

Statement (1) Statement (2) (a) False False (b) False True (c) True False (d) True True

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SECTION B

Answer any TWO questions from this section

1. Redhill Aggregates PLC is considering two investments in new projects, Z345 and Y627. Each project will require an initial cash outlay of £18 million. Additional investment in working capital is insignificant. The expected returns on each of the investments in the next five years is as follows (all figures are in £000):

PROJECT NO. Z345 PROJECT NO. Y627 YR. Cash Depreciation Profit Cash Depreciation Profit inflow inflow 1 12,000 9,000 3,000 3,000 3,600 −600 2 8,000 6,000 2,000 6,000 3,600 2,400 3 4,000 3,000 1,000 8,000 3,600 4,400 4 10,000 3,600 6,400 5 5,000 3,600 1,400

The company uses different accounting policies for the fixed assets in view of the nature of their use and the pattern of earnings that they generate.

Required:

(a) Create a table showing (and explaining) all the relevant calculations you make. [50%]

(b) What is the payback period for each investment? [10%]

(c) What is the net present value of each investment? Assume that a cost of capital of 10% per annum is appropriate for both projects. [10%]

(d) Which of the two projects is to be preferred, if they are independent and mutually exclusive? Give your reasons and explain any other factors that might affect the decision of the management of Redhill Aggregates PLC. [30%]

2. (a) Distinguish between Debt (Bonds), Hybrid (Preference shares) and Equity (Ordinary Shares) preferably using a Payoff versus State of Economy Diagram. [60%]

(b) What kind of financing is ideal for a buy-to-let property investor? Explain. [20%]

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3. You have just started a highly paid job working in a company that provides financial consultancy services. They have sent you to a client company where they are conducting consultancy work aimed at converting the client’s project appraisal technique to use the NPV method. Your colleagues have collected most of the required information but are stuck at the essential step of calculating the client company’s WACC. According to your CV you are quite an expert in finance so you get sent along to finish the job.

Here are the facts you are given:  there are 45 million ordinary shares of 20p each.  there is an £5 million bank loan at 8% per year.  there is £55 million nominal of bonds currently issued. These have a 5% annual coupon and current market value of £90 per £100 nominal.  the current market price of ordinary shares is £1.95.  the shares have just gone ex-dividend.  the last paid dividend was 25p per share.  dividends are expected to increase at 3% per year.  the corporate tax rate is 30% and the normal tax rules apply with respect to interest and dividends.

Report requirements:

(a) Calculate the debt to equity ratio. [20%]

(b) Give a detailed discussion of how the cost of capital of each component that goes to make up the WACC is calculated. Be sure to mention: o how the equity cost of capital may be calculated using the dividend growth model. o the effect of taxation. [60%]

4. (a) Explain the basic concepts behind Modern Portfolio Theory with the help of neat diagrams. Illustrate the efficient frontier on the diagram and show how it changes as one moves from a Markowitz’s perspective to that of Sharpe. How does this change impact on the optimal portfolio selection for a risk-averse investor? [60%]

(b) Explain the basic concept of Efficiency of Markets using the Sharpe frontier. What are the different forms of Efficiency? Is the empirical evidence consistent with the theory? [40%]

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