400137 1 Present Value Tables Attached THE UNIVERSITY OF BIRMINGHAM Sessional Examination for Degree of Master of Business Administration Finance for Managers 0702890 (ACC G29H) January 2004 ‘Time allowed: 3 hours Calculators may be used in this examination provided they are not capable of being used to store alphabetical information other than hexadecimal numbers ‘This paper has two sections; SECTION A (Questions 1 to 5) and SECTION B (Questions 6 to %» You are required to answer FOUR questions in total. You must answer at least one question from Section A and one question from Section B. All questions carry the same total marks.400137 2 SECTION A (Answer at least ONE question from this question) Asa finance manager of HR Ltd. you have been asked to advise the management which of the following two projects you should accept. You have calculated that the cost of capital for financing the project will be 10% per annum. You are however cconcemed sbout the future economic environment and you anticipate that there is a 25% chance of economic growth, 25% chance of a recession and 50% chance that the economy will grow as normal, The estimated investments costs and cash inflows for the two projects under different economic conditions are as follows: Project A(£000's) Project B (£000's) Year Normal Growth Recession Normal Growth Recession 0 -500 -500 -500 +700 -700=—-700 1 100 120 70 80 120 60 2 120 150 80 150 170 100 3 140 170 100 180-225 150 4 160 190 120 220° 250 200 5 180 210 130 230 © 300 210 6 180 220 150 250 351 230 Required: @ © Assuming that the projects are mutually exclusive, suggest which project HR Ltd should select. (15 marks) Discuss the limitations of Internal Rate of Retum (IRR) technique and explain why IRR is not suitable when projects are mutually exclusive and when a firm faces capital rationing. (10 marks) (25 marks in total) ‘TNT Ltd is considering investment in plant for the manufacture of a new product, the demand for which is estimated to be 50,000 units a year for next five years. The plant is estimated to cost £1,200,000 (payable immediately) and will have no residual value. The selling price per unit is estimated to be £12 while labour and material cost is estimated at £2 and £3 per unit respectively. Overhead costs are not expected to change. The cost of capital is estimated to be 10 per cent. The project will not require any investment in additional working capital. Assume that there are no taxes and all cash flows arise at the end of each year. Required: @ ® Advise TNT Lid. whether it is worthwhile investing in this project? (S marks) How sensitive is this project with reference to the cost of plant, annual sales volume (quantity), selling price, labour cost, cost of capital and the life ofthe project? (20 marks) (25 marks in total) Turn Over00137 3 3. Sharp Plc. is financed by: 8) 1,000,000 ordinary shares (nominal value £1 each). Last year’s dividend was £0.20 per share and itis estimated that each year the dividends are expected to grow by 10 per cent of the previous year’s dividend, The current market price of the share is £1.50 per share; and 'b) £500,000 (nominal) bonds which pay annual interest of 8 per cent (of nominal) for five years. At the end of five years, the bonds will be redeemed at nominal value. Currently the bonds are trading at a price of £96 (per £100 nominal). ‘The corporation tax is 35 per cent. Reauired: (@) Calculate the Weighted Average Cost of Capital (WACC) for Sharp Plc. Use market values of equity and debt in calculating WACC. Consider the impact of taxes in your WACC calculations. (15 marks) (©) What is gearing and how does excessive gearing cause financial risk? (10 marks) (25 marks in total) 4, As asharcholder of Queen Pic you wish to calculate expected retums of its shares. ‘You have leamt from financial press reports that last year the retums form the FTSE ALL index were a mere 7%, You have further gathered information which suggests that over last few years, the FTSE ALL index returns have been quite volatile and financial experts estimate that standard deviation of FTSE ALL retums have been around 12%. You are aware that shares of Queen Plc have been somewhat more volatile than the FTSE ALL index and your estimate suggest that the standard deviation of Queen Plc retums have been 15%, However, market reports show that Queen Plc’s shares are poorly correlated with FTSE ALL index which is estimated to be 30%. Current risk free rate of interest on government securities is 3.75%. Required: (@) Calculate the expected retum on Queen Plc’s shares. (1S marks) (b) Discuss the main limitations of the Capital Asset Pricing Model? (10 marks) (25 marks in total) Turn Over