INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD

FACULTY OF MANAGEMENT SCIENCES

Final Exam Spring 2020

Paper Type: Subjective

Course Name: Financial Management Instructor: Shumaila
Total Marks: 60 Time Allowed: 8 Hours
Batch Name: BS (AF) 7
Attempt all the following questions. All Questions carry equal marks.

Question 1
Home Products, Inc. (HPI) is a leading manufacturer of prescription and ethical drugs; specialty
foods and candies; and proprietary drugs. Important product names include Advil, Anacin,
Dimetapp, Norplant and Robitussin. Total revenues in the last fiscal year were in excess of $9
billion.
Long Term Debt
The company has a capital structure that is made up of 34 percent long-term debt, 3 percent
preferred stock, and 63 percent common stock. One of the two largest domestic long-term debt
issues is a 9 1/8 percent coupon bond that is due in 26 years. This debenture is currently selling for
$930. The bond is callable in seven years and if called will be redeemed at a premium of 104.4375.
The other large publicly held bond is a 9 percent coupon bond that is due in nine years. This
debenture is selling for $972.50. Both of these bonds are rated A by Moody’s.
Preferred Stock
The preferred stock is $2.75 cumulative preferred with a stated value of $30.50, but it is currently
selling for $30. More than 5.5 million shares were issued in February 1979 in connection with a
merger of FDS Holding Company into a subsidiary of HPL. The preferred stock has no voting
rights unless the company is an arrears on six or more quarterly dividends, and then each
shareholder is entitled to one- quarter vote per share. In the event of liquidation each share is
entitled to $30.50 plus accrued dividends.
Common Stock
Returns from common stock come from the cash dividend payment and/or changes in the price of
stock. Investors receiving dividends can expect them to grow over time, but some stocks do not
pay dividends, especially during their early growth years. As firms mature, they typically start
paying dividends and then management is very reluctant to reduce the dividend. For the firms that
do not pay dividends, the normal assumption is that the earnings are being retained by the firm to
promote growth; thus, the stock price should grow at a higher rate than firms that have high
payment ratios.
 INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
FACULTY OF MANAGEMENT SCIENCES
Final Exam Spring 2020

Two major factors that affect the price of stock are changes in the required rate of return caused,
primarily by changes in the risk, and change in the growth rate of earnings, which is turn create
changes in the growth rate of dividends.
The common stock of Home Products currently has over 95 million shares of $ 3.125 par value
stock outstanding. A share of common stock presently sells for $405/8 and pays a quarterly dividend
of $0.385. A consensus estimate (Zack’s and IBES) indicates that earnings and dividends are
expected to grow at an annual rate of 9.7 percent for the next five years. The common shares have
no preemptive rights. Stock holders of HPI have the opportunity to buy additional shares of
common stock through a plan of automatic dividend reinvestment optional cash purchase. This
plan allows stock holders to have their dividends reinvested in shares of common stock, and they
can purchase additional shares at the market price (with no commission) each month. Shareholders
who participate in this plan are limited to a total of $1000 per month that they can use to purchase
additional shares.
QUESTIONS

1. Look at the 9 1/8 percent coupon bond. What is the current yield, its yield-to-first call and
its yield-to-maturity?
2. Do you think this bond will be called? Why or why not?
3. What would be the value of the 9 1/8 percent coupon percent if the time of maturity was 10
years rather than 26 years? Can you explain why your answer is correct?
4. What is the required rate of return for the preferred stock? How does this rate compare to
the YIM for the HPI 9 1/8 percent bond? Is this difference what would you have expected
from a risk/return standpoint? Why or why not?
5. In the event of liquidation, HPI preferred stockholders are entitled to $30.50 plus accrued
dividends. Does this mean that preferred stockholders will receive that amount?
6. What is the dividend yield and the expected capital gains yield for HPI common stock?
7. Given that HPI selling for $405/8, what is its required rate of return? (Use the constant
growth valuation model.)
8. Assume that the risk-free rate is 7 percent and that the expected return of the market is 12
percent. According to the security market line valuation model, what is the required rate of
return for HPI common stock if its beta is 1.10?
9. Using the constant growth valuation model, find the present value of HPI common stock.
Would you buy or sell?
10. The constant growth value is used in text books as a conceptual model to explain changes
in stock prices. Is the model also of value for the actual valuation of stocks?

Question 2
The management of Taylor Brands has a philosophy of “better to be safe than sorry” when
selecting a discount rate. At present the firm uses a 30 percent rate, which many company
executives feel is unreasonably high and results in the following difficulties. First, some projects
considered to be worthwhile and important are rejected because their expected return is close to,
but still below, the 30 percent minimum. Second, managers have a tendency to be overly optimistic
 INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
FACULTY OF MANAGEMENT SCIENCES
Final Exam Spring 2020

in their cash flow projections in order to get their pet projects accepted. Third, there is the feeling
that the rate is at best arbitrarily determined and at worst something that Trevor Unruh-Taylor’s
general manager- has “pulled out of a hat”.
ROBERT WEST
Robert West is one of Taylor’s more innovative and thoughtful executives. A few years ago he
correctly perceived that a successful firm in the food wholesaler’s industry-Taylor’s main industry-
would have to expand into nonfood items. After extensive study, West recommended that Taylor
add such products as light hardware and paper plates to the variety of goods it sells to grocery
stores. This strategy worked remarkably well. Taylor’s customers benefited because they dealt
with fewer vendors and invoices. Taylor gained customers (many were referrals) and also reduced
its unit cost by making more efficient use of its trucking capacity.
West has developed an interest in the financial side of business. During the past year he attended
two seminars on cost of capital estimation, using his personal leave time and at his own expense.
He has been eager to apply this newly acquired knowledge, and after a number of discussions
Unruh told West to “determine Taylor’s cost of capital and make a formal report on your findings”.
It seemed to West that this was a major coup since Unruh paid little attention to the financial side
of the business. He was told privately, however, that Unruh is “really unimpressed and bored with
the entire idea; he assigned you this project because he knew you were eager to do it, and Unruh
admires your initiative”. West was told quite bluntly that “nothing will come of your efforts”.
Initially deflated, West became determined to do a thorough evaluation, and he felt sure that he
could convince Unruh of the importance of obtaining and accurate cost of capital. “At the very
least,” West thought, “a formal investigation of our cost of capital will eliminate the perception
that is arbitrarily determined.”
In preparation for making the estimate West reviewed is notes from one of the seminars he had
attended. (See Exhibit 1) He recalled the instructor emphasizing that estimating the required return
on equity was especially delicate; and although the instructor gave two models for measuring this
return, he emphasized there was “no substitute for good judgment.”
FINANCIAL INFORMATION
West also collected some financial information that he felt was relevant to analysis. He knows
the company has recently obtained a bank note at 7 percent and that the company’s bonds were
originally issued at 7 percent but are currently selling at a discount with a yield to maturity of about
8 percent.
Taylor’s EPS has grown quite impressively in the last five years (see Exhibit 3), but West knows
Unruh encouraged a relatively constant dividend per share over this period since he preferred to
reinvest much of the company’s earnings. West doesn’t believe this will continue since Unruh is
under pressure from major stockholders to bring dividend growth in line with earnings growth.
Nor is it likely that past EPS growth can be maintained. First, during this period the industry itself
had unusual prosperity. Second, some of this past growth was a result of the firm’s movement into
 INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
FACULTY OF MANAGEMENT SCIENCES
Final Exam Spring 2020

nonfood items, and these opportunities are virtually exhausted. Third many corporate insiders felt
Taylor had been a bit lucky.
West decides it is reasonable to suppose that Taylor will implement a 70 percent payout ratio; after
all, it makes no sense to retain a large proportion of earnings when investment opportunities are
not as plentiful as in the past. He also fells that the company will achieve an average return of 12
percent on any retain earnings. Though these figures on payment and return are some-thing of
“guesstimates, West was able to find support for these numbers among Taylor’s managers.
Most financial analysts consider the Industry to be of average risk, and in fact, beta estimates for
Taylor range from 8 to 12.West decides, however, that these estimates are a bit high, because the
firm is in the process of altering production techniques that will reduce the company’s degree of
operating leverage.
And there is another difficulty. At present Taylor has no preferred stock in its capital structure.
But West knows that there are plans to issue some in the next few months, though the price and
dividend per share have not yet been determined. However, he does have some information on the
preferred stock of three of Taylor’s competitors. (See Exhibit 6.) These companies are much larger
than Taylor and are considered less risky because they have a more diversified product line and
customer base and enjoy a lower degree of operating leverage (even after the change in Taylor’s
production techniques). He is also aware that the yield difference on the preferred stock of firms
in roughly the same industry is 75 to 100 basis points.
“I’ve got quite a bit of info, West thought. I hope I can put it all together to make a report that will
impress Unruh.”
QUESTIONS

1. West intends to adjust Taylor’s beta estimates slightly downward in view of the fact that
the firm’s degree of operating leverage is decreasing. Does such an adjustment seem
appropriate? Explain
2. The required return on equity (cost of equity), Ke, can be estimated in a number of ways.
(a) Estimate Ke using a risk premium approach.
(b) Use the dividend valuation model to estimate Ke.
(c) In your view, what is Ke? Justify your choice.
3. Estimate Taylor’s cost of capital or required rate of return. (You may use book values in
your calculations. Assume the existing capital structure is optimal and ignore preferred
stock. The relevant tax rate is 40 %.)
4. Preferred stock is a riskier investment than a bond. Yet companies have been known to
issue preferred stock at a lower yield than they issue bonds. How can this be, assuming
investors are rational?
5. (a) Estimate the cost of preferred stock (required return of preferred stock).
(b) Redo question 3 including preferred stock as a financing source, and assume the target
weights are as follows: notes, 5 %; bonds, 40%; preferred, 5%; equity, 50%.
6. What additional information would you like in order to make more informed estimates
about the cost of equity and the cost of preferred stock?
 INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
FACULTY OF MANAGEMENT SCIENCES
Final Exam Spring 2020

7. Would you recommend that West use market or book values in is presentation? Defend
your recommendation.
8. Apparently the 30% hurdle rate used by Taylor exceeds its actual cost of capital or required
rate of return. Let us suppose a company errs in others direction and choses a hurdle rate
considerably less than its actual cost of capital. What difficulties could this cause?
9. West believes that Taylor’s high cost of capital encourages managers to develop overly
optimistic cash flow forecasts. Is a more accurate cost of capital estimate likely to reduce
this bias, as he apparently thinks? Explain your answer.
 INTERNATIONAL ISLAMIC UNIVERSITY ISLAMABAD
FACULTY OF MANAGEMENT SCIENCES
Final Exam Spring 2020

Question 3
Discrepancies and misrepresentation along with financial scams are faced by many corporations.
Can you give an example from real world?

Success comes only to those who believe in themselves and are prepared to win. Good luck.