Tables of discount factors and annuity factors are provided in the appendix at the end of the paper.

Transcription

1 UNIVERSITY OF EAST ANGLIA Norwich Business School Main Series UG Examination BUSINESS FINANCE NBS-5008Y Time allowed: 3 hours Answer FOUR questions out of six ALL questions carry EQUAL marks Tables of discount factors and annuity factors are provided in the appendix at the end of the paper. In each exercise attempted, you should explicitly state all formulas used in your calculations and also present your workings. Notes are not permitted in this examination Do not turn over until you are told to do so by the Invigilator NBS-5008Y Module Contact: Dr Georgios Daskalakis, NBS Copyright of the University of East Anglia Version 1

2 Page 2 1. a) You can buy a property today for 3 million and sell it in 5 years for 4 million. i) If the interest rate is 8%, what is the present value of the sales price? If you earn no rental income on the property, is buying the property an attractive investment for you? (2 marks) i Would your answer to ( change if you also could earn 200,000 per-year rent on the property? You may assume that rent is paid at the end of each year. (8 marks) b) British Quince comes across an average risk investment project that offers a rate of return of 9.5%. This is less than the company s normal rate of return, but one of Quince s directors notes that the company can easily borrow the required investment at 7%. It s simple, she says. If the bank lends us money at 7%, then our cost of capital must be 7%. The project s return is higher than the cost of capital, so let s move ahead. How would you respond? c) Why are mutual funds called financial intermediaries? Why does it make sense for an individual to invest her savings in a mutual fund rather than directly in financial markets? Briefly explain.

3 Page 3 2. a) Consider projects A and B with the following cash flows: Project Initial Cash flow at Cash flow at Cash flow at investment end of year 1 end of year 2 end of year 3 A $36 +$20 +$20 +$20 B $50 +$25 +$25 +$25 i) Which project has the highest Net Present Value (NPV) if the discount rate is 10%? Which project has the highest profitability index? i Which project is most attractive to a firm that can raise an unlimited amount of funds to pay for its investment projects? What about in the case when the firm can only raise a limited amount of funds? b) If you insulate your office for 10,000, you will save 1,000 a year in heating expenses. These annual savings will last forever. i) What is the NPV of the investment when the cost of capital is 8%? What about in the case when the cost of capital is 10%? What is the Internal Rate of Return (IRR) of the investment? (3 marks) i What is the payback period on this investment? (2 marks) TURN OVER

4 Page 4 3. A firm considers launching a new product in the market that is expected to generate the following revenues: Year Revenues 1 40, , , ,000 Thereafter 0 Expenses are expected to be 40% of revenues, and working capital required in each year is expected to be 20% of revenues in the following year. The product requires an immediate investment of 45,000 in plant and equipment. i) What is the initial investment in the product? (Hint: Remember working capital.) i If the plant and equipment are depreciated over 4 years to a salvage value of zero using straight-line depreciation, and the firm s tax rate is 40%, what are the project cash flows in each year? (10 marks) If the opportunity cost of capital is 12%, what is the Net Present Value (NPV) of the project? Should the firm proceed with launching the product? b) A manager attempts to persuade her bank to provide additional funding for continuing the development of a new product by arguing that: It would be foolish to abandon a project on which nearly 100 million has already been spent. Do you support this argument? Briefly explain.

5 Page 5 4. a) You need to estimate the value of Laputa Aviation. You have the following forecasts (in million ) of its profits and its future investments in new plant and working capital: Earnings before interest, taxes, depreciation and amortization (EBITDA) Year Depreciation Pre-tax profit Investment From year 5 onward, EBITDA, depreciation, and investment are expected to remain unchanged at year-4 levels. Laputa is financed 50% by equity and 50% by debt. Its cost of equity is 15%, its debt yields 7%, and it pays corporate tax at 40%. i) Estimate the company s total value. (15 marks) What is the value of Laputa s equity? b) Geothermal has a Weighted Average Cost of Capital (WACC) equal to 11.4%. Executive Fruit s WACC is 12.3%. Now Executive Fruit is considering an investment in geothermal power production, that is, what Geothermal is involved in. Should it discount project cash flows at 12.3%? Why or why not? TURN OVER

6 Page 6 5. a) Below is the market-value balance sheet of the United Frypan Company: Net working capital Long-term assets Market-Value Balance Sheet $20 Debt $40 $140 Equity $120 $160 $160 Assume that Modigliani and Miller s theory holds except for taxes. There is no growth, and the $40 of debt is expected to be permanent. Assume a 35% corporate tax rate. i) How much of the firm s value is accounted for by the debtgenerated tax shield? i What is United Frypan s after-tax Weighted Average Cost of Capital (WACC)? The return on debt is 8% and on equity 15%. Now suppose that a law is passed that eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? Assume an 8% borrowing rate. (8 marks) b) What is the pecking order theory of optimal capital structure? If the theory is correct, what types of firms would you expect to operate at high debt levels? Briefly explain. (7 marks)

7 Page 7 6. a) Suppose that you own 1,000 shares of Nocash Corp. and the company is about to pay a 25% stock dividend. The stock currently sells at $100 per share. i) What will be the number of shares that you hold after the stock dividend is paid? (3 marks) i What will be the total value of your equity position after the stock dividend is paid? (7 marks) What will be the number of shares that you hold if the firm splits five for four instead of paying the stock dividend? (3 marks) b) Payout policy: i) Why are dividend increases typically good news for investors and dividend cuts bad news? Briefly explain. (6 marks) Why would payout policy not affect firm value in an ideal world? Briefly explain. (6 marks) V TURN OVER

8 Page 8 APPENDIX Discount factors: Present value of 1 to be received after t years Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% Annuity factors: Present value of 1 per year for each of t years Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% END OF PAPER

9 Examination Feedback NBS-5008Y Business Finance, Structure of the exam Students were required to address 4 out of 6 exercises. Each exercise was equally weighted. Marks distribution Mean 62.0%, Standard deviation 23.1% General comments The overall performance in the exam was very good, with the majority of the 235 students sitting the exam obtaining a mark of 60% or higher (57.87%). The maximum mark awarded was 96% (2 students) while, 41 students failed (17.45%). Almost all students attempted exercises 2, 3 and 4 (see Figure 1). Exercise 5 was the least popular with only 1 out of 8 students attempting it, followed by exercise 6. Students performed particularly well in all exercises with the exception of 5 and 6, that is, the two least popular ones (see Figure 2). Figure 1: Number of students attempting each exercise Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 1

10 Figure 2: Average mark obtained per exercise 20.00% 18.6% 15.00% 15.2% 16.6% 16.1% 10.00% 7.1% 8.0% 5.00% 0.00% Exercise 1 Exercise 2 Exercise 3 Exercise 4 Exercise 5 Exercise 6 Note: The maximum mark per exercise is 25 out of 100 (25%). Feedback for each exercise Exercise 1 Most marks were missed in the second and third part of the exercise. In the former, a lot of students failed to recognise the fact that the investment decision should be made separately to the financing decision and incorrectly based their argument on how the firm s WACC will change when the investment is financed through debt. In the latter, most students failed to show an understanding of the key benefit of investing in mutual funds, that is, low cost diversification. Instead, they were incorrectly stating that mutual fund investments entail lower risk and higher return for investors relative to directly investing in financial markets. Exercise 2 A lot of students missed marks in the first part of the exercise as they failed to recognise the fact that when a firm is considering two positive NPV projects that are not mutually exclusive, then both should be pursued if there is no capital rationing. Most marks were missed, however, in the second part with students calculating the PV of the perpetuity but 2

11 failing to compute the NPV. Consequently, they were not able to use these insights for finding the IRR. Exercise 3 Most marks were missed in the calculation of the operating cash flows in the first part of the exercise due to students not dealing properly with the changes in working capital. A lot of students also failed to recognize in the second part that the capital already spent is a sunk cost and, therefore, irrelevant for the decision whether to continue funding an investment. Instead, these students were solely basing their argument on the validity of the statement on whether the NPV of the investment is positive or not. Exercise 4 Most marks were missed in the calculation of the firm s total value in the first part of the exercise. This was due to either not properly accounting for the value of the firm after year 4 or not correctly computing the firm s free cash flows. With respect to the former, a lot of students after calculating the PV of the perpetuity at year 4, forgot to discount this value to the present. Exercise 5 Only a small number of students was able to properly address the first part of the exercise and particularly its third sub-part. This was due to students not being able to properly compute the firm s tax shield for the first 5 years. In the second part of the exercise, a lot of students were discussing not the pecking order theory but rather the trade-off theory of optimal capital structure. Most importantly, many students forgot to answer what firms are expected to operate at high debt levels. Exercise 6 Most marks were missed in the second part of the exercise with only a very small number of students able to properly discuss why payout policy doesn t affect firm value in an ideal world (MM dividend-irrelevant proposition). However, even in the first part, most students failed to recognize that in the case of a stock dividend shareholders receive additional new stocks and not cash. 3