Module Contact: Dr A Shamshur, NBS Copyright of the University of East Anglia Version 1

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1 UNIVERSITY OF EAST ANGLIA Norwich Business School PG Examination ADVANCES IN FINANCIAL MANAGEMENT NBS-MD01 Time allowed: 2 hours Answer TWO questions only All questions carry equal marks Notes are not permitted in this examination. Do not turn over until you are told to do so by the Invigilator. NBS-MD01 Module Contact: Dr A Shamshur, NBS Copyright of the University of East Anglia Version 1

2 Page 2 1. Capital Structure Eastwell needs 1m to establish the business. The founders are considering their options with regard to capital structure. The business required return for an all-equity firm is 15%. The expected annual cash flow is a constant 160,000 in perpetuity. This cash flow will be paid out each year to the suppliers of capital. The three ways of raising these funds being considered are: Structure A. Selling 500,000 shares at Structure B. Selling 300,000 shares at 2.00 and borrowing 400,000 with an interest rate 12%. Structure C. Selling 100,000 shares at 2.00 and borrowing 800,000 at an interest rate 13%. Taxes may be ignored. a) Calculate for each structure the debt interest, earnings available to shareholders, return on equity, return on debt, WACC, total market value of debt and total market value of equity. (50 marks) b) Explain the terms business risk and financial risk. c) Some scholars advocate the high use of debt because of the positive effect on managerial actions. Describe these ideas and consider some counter-arguments.

3 Page 3 2. Dividend Policy a) A firm, which has had a history of high growth and pays no dividends, announces that it will start paying dividends next quarter. How would you expect its stock price to react to the announcement? b) According to the signalling theory of dividends, what does management consider when setting the current dividend? Is the decrease in dividend payments considered to be a positive or negative signal? Explain. Will markets always believe the signal? Why or why not? c) Explain under which conditions an increase in dividend payment can be interpreted as a signal of bad news. d) If the clientele theory is correct, what is the optimal dividend policy for the typical firm? Explain. e) List the conditions under which stockholders are better off if the firm uses surplus cash to repurchase shares rather than pay a dividend. TURN OVER

4 Page 4 3. Risk in Project Analysis a) Explain the Mean-Variance rule for choosing between two projectsinvestments. b) The firm VEM plc is considering the following investment projects: Project A: This project may yield a return of 1m with probability of 0.3, 3m with probability of 0.4 and 5m with probability of 0.3. Project B: This project may yield a return of - 1m with probability of 0.2, 2m with probability of 0.6 and 10m with probability of 0.2. Project C: This project will yield a certain return of 2m with probability 1. i. Compute the expected return and standard deviation for each project. (50 marks) ii. Using the Mean-Variance rule, explain whether project A or B is more preferable to the firm. Using only the Mean-Variance rule, can we compare Project A with Project C?

5 Page 5 4. Portfolio Theory a) Discuss the Efficient Frontier and its importance in optimal portfolio decisions. b) Shares X and Y have the following expected return and standard deviation: Expected Returns: RX 25%, RY 35% Standard Deviations: 15%, σ 20% X Y i. What is the expected return and standard deviation for a portfolio composed of 40% in X and 60% in Y assuming the correlation coefficient between X and Y is 0.5? ii. iii. What is the expected return and standard deviation for a portfolio composed of 40% in X and 60% in Y assuming the correlation coefficient between X and Y is -0.7? (i. and ii. 50 marks) Based on your answers in b)i and b)ii, discuss the importance of the diversification principle. TURN OVER

6 Page 6 5. Efficient Market Hypothesis a) Summarise the different categories of the efficient market hypothesis. b) Summarise the empirical evidence relating to the efficient markets hypothesis for advanced industrialised countries like the United Kingdom and the United States. (40 marks) c) Explain whether it can be profitable to use technical analysis of stock price trends in an efficient market. d) Explain whether it can be profitable to use fundamental (or intrinsic) analysis of stock prices in an efficient market. e) Explain why professional and highly paid fund managers generally produce returns less than those available on a broadly based market index.

7 Page 7 6. M&A Nut plc. and Bolt plc. have made separate all-share bids for Hammer plc. Nut Bolt Hammer Nut+Hammer Bolt+Hammer Pre-merger share price Number of shares issued Market Capitalisation m 2m 1.5m 4m 6m 1.5m 6.8m 8.0m Assume no transaction costs. Required: a) If you were the managing director of Nut, what is the maximum number of Nut shares you would offer for every 10 Hammer shares? (Fractions of shares may be used.) b) If you were the managing director of Bolt, what is the maximum number of Bolt shares you would offer for every 10 Hammer shares? (Fractions of shares may be used.) c) Some mergers produce increased returns for the acquirers shareholders, whereas others do not. Discuss the reasons for merger failure from the acquirers perspective. d) Explain what happens to post-merger earnings per share when a company with a relatively high price-earnings ratio acquires a company with a lower price-earnings ratio, given that the transaction is in the form of an exchange of ordinary shares and no synergy exists. What would happen if the acquirer s price-earnings ratio was lower than the price-earnings ratio of the acquiree? Use examples to assist your explanation. e) What motivates a company to acquire other companies? END OF PAPER