EBS Finance Theory Q&A-Past Papers-Asif Gul

Past Paper Dec-2017
Q1. Identify and discuss the factors that affect a company’s equity beta?
Ans. The main factors affecting the level of the equity beta are the level of business risk in the
company, the level of operating leverage and the amount of debt in the capital structure.
The business risk is the amount of competition in the company’s sector of the economy, the ability
to develop new products, the ability to control input costs, and the amount the business cycle
affects the company. The more these impact on the company, the higher the beta. For example,
an industry where there is fierce competition is riskier than where the rival firms tacitly agree not
to compete too hard against each other.
The level of operational gearing refers to the amount of fixed costs in the operations of the
company. If there are high fixed costs, e.g. in the airline business and the auto business, then
there will be higher betas. The firm has to generate more cash flow to cover these costs, before
shareholders get their return. A similar thing can be said about debt. The debt has to be paid
before the shareholders are paid, so debt contributes to a higher beta. Companies with higher
business risk and high operating leverage would be advised not to take on too much debt.
Q2. Explain what is meant by systematic risk and unsystematic risk. Where do they play a
role in finance?
Ans. Systematic risk is the risk that all companies face. It is the risk they face when large
macroeconomic factors are at play. It is the impact that higher inflation has on all companies; it is
the impact that a recession has on companies. The systematic risk is the risk that is reflected in
all companies’ equity betas. It is undiversifiable risk. The equity beta will measure individual
companies’ reaction to these macroeconomic factors relative to the overall stock market.
Unsystematic risk is the unique risk in a company that can be diversified away through owning
the market portfolio. The unique risk is the risk that you face by holding a single share. For
example, in 2015 you may have felt safe holding Volkswagen as the single share in your portfolio.
After all it was the largest car manufacturer in the world. What could go wrong with that
investment? The company was worth over €100bn on the stock market. But in September 2015
the diesel emissions scandal wiped off 50% of that value in the space of a few weeks. If VW was
held in the market portfolio, that 50% decline would have had a negligible effect on the portfolio’s
value.
The unsystematic risk is assumed to have been diversified away by investors and the remaining
risk, the systematic risk, is what they get rewarded for; that is reflected in the equity beta in the
capital asset pricing model.
Q3. What are the advantages and disadvantages of EPS growth versus Economic Value
Added (EVA) as a reward measure for top managers at this company and any company?
EPS is based on accounting earnings. There is no consideration of the cost of capital for the
company. Basing decisions on EPS growth could lead the managers to take the wrong decision
and may not lead to wealth being created for shareholders. Using Economic Value Added is more
likely to lead to shareholder wealth creation.
Too many companies are basing reward on EPS growth or profitability. This is based on
accounting numbers only. EVA uses the accounting numbers (a disadvantage) but relates these
Asif Gul-Theory Q&A –Finance Past Papers

to an economic cost of funds. This is the total assets multiplied by the WACC. The company
should deliver income greater than this number. A company can be reporting profits but still be
destroying shareholder wealth. EVA attempts to measure the wealth that managers are adding to
shareholders. EVA is a better measure than EPS growth. EVA has the advantage of using an
economic cost of capital to measure corporate returns against.
The main advantage that EPS has over EVA is the ease of calculation. For EPS, the net income
is divided by the number of shares, which is very straightforward. EVA requires a number of
stages to calculate the final number.
Q4. Which of book value or market value figures are used in the following situations?
Explain why they are used.
(a) Lenders looking to advance money to a company
(b) The WACC calculation
Ans. With the WACC we are looking for a discount rate for all the corporate cash flows by
combining the rates for debt and equity. The rates for debt and equity are based on their
proportionate claims upon the corporate cash flow. The combination of debt and equity must be
based on their market values to reflect the ratio of their claims on the cash flow.
The WACC is an average of the rates that all capital claims require on the amounts they have
invested in the company. The amounts they have invested are not the cash they paid in, but the
market prices which they could sell these claims for. The WACC then is the market value weighted
average of the rates required by debt and equity.
Past paper Aug-2017
Q1. Explain what biases there might be in a capital budgeting project, and explain how
they might be overcome.
Ans. Among the biases that affect capital budgeting projects a main one is overconfidence. If the
forecast for cash flows is over-optimistic, the NPV is likely to be higher than it should be, and so
what might be a negative NPV project becomes a positive NPV project. Projects that particular
managers want done may suffer from this over-optimism. If managers have put a lot of time and
effort into a proposal for a project, they can be prone to inflate the cash flows to put the project in
a more favourable light. The managers may have compensation tied to the level of sales or
volume of assets, so they may have a vested interest in taking on what look like unattractive
projects, leading to them overstating the benefits of the project.
Companies are over-optimistic on the selling price of their products and underestimate the level
of competition and its impact on selling prices. An example is the continual downward pressure
on mobile phone charges and broadband charges: the intense competition drove prices down
more quickly than companies had prepared for, so profitability in the sector was lower than it
should have been.
This can also work in reverse: some managers may be overly cautious, and avoid risky projects,
if there is a chance they will be penalized for losses.

Another area of bias is with the discount rate. The lower the discount rate the more valuable the
cash flows. If the company can convince investors that the relevant discount rate should be lower,
a project will look more valuable.
Another bias is in the treatment of inflation. Companies should preferably discount nominal cash
flows with a nominal discount rate, or real cash flows with a real discount rate. Mixing these up
will lead to incorrect decisions.
To overcome these problems, all departments should be informed how to handle the inflation
problem with regard to cash flows. This will lead to consistency. With over-optimistic estimates of
cash flows, all project proposals should be routed through finance departments, where they would
be subject to an audit and sensitivity test. The managers should be rewarded for the amount of
wealth that is created by their projects, so an Economic Value Added analysis would help here.
Q2. Describe the impact that inflation has on depreciation values, salvage values, and their
tax in capital budgeting.
Ans. Inflation will affect the operating cash flows of a project: for example, wage costs might rise
by 4% per annum; sale prices may rise by 3% per annum. When it comes to depreciation, the
annual depreciation charge is fixed at the time of purchase, so a £200,000 machine with a 10-
year life being depreciated straight line to zero will have £20,000 of depreciation in year 1 and
£20,000 of depreciation in year 10. This applies even if inflation is, say, 10% per annum, which
would greatly reduce the real value of the final year’s depreciation. If inflation was 10% and the
tax rate 30% then the real value of the tax shield is not £6,000 but £2,313 (£6,000/1.1010).
With salvage values, these would tend to rise with inflation. Continuing the example from above,
if the company expected a salvage value of £10,000 at the end of 10 years, they would pay £3,000
tax on it (machine is fully depreciated, £10,000 taxed at 30%). If the salvage value rose by the
rate of inflation during the 10 years, the final salvage value would be £25,937, and the tax due
would be £7,781.
So with depreciation and inflation, the company will lose out on the real value of the depreciation
tax shield – the tax shield benefit will progressively fall in real terms. And with the salvage value
the company will be penalized if it rises in value with inflation when they come to sell it – they will
pay too much tax.
Q3. What are the agency concerns surrounding the dividend payment and the share
repurchase?
Ans.The dividend represents cash leaving the company. This is a concern to bondholders. They
want their interest paid each period and they want their capital repaid at the end of the bond’s life.
If by paying (large) dividends the company weakens that likelihood, this is against the interests of
the bondholders. They will usually insert clauses in the bond contract limiting the amount that can
be paid out as dividends.
As far as shareholders are concerned, the dividend is part of the return they would expect to
receive from the company. They are not guaranteed a dividend – the bondholders come first. But
if the company is making good profits, the shareholders would expect a cash dividend. If the
company decides to make a share repurchase instead of a dividend payment, it may be for the
benefit of the directors, who have executive options which don’t receive dividends. For the

directors, the payment of the dividend does not particularly help them, whereas the share buyback
should push the share price higher (although it shouldn’t affect the overall value of the company).
The directors may also decide to pay a share dividend rather than a cash dividend. The
shareholders do not benefit here. They own the same stake in the company, and they don’t have
a cash dividend.
With the share repurchase, the shareholder is not receiving a payout (the dividend), but the share
price will not drop as it does with the dividend payment. In theory, without tax, the shareholder
should have the same wealth; with the dividend payment, the dividend and the ex-dividend share
price should be the same as the share price with the share repurchase. But with taxes, the
shareholder loses some value. With the share repurchase, taxes will only be paid when the shares
are sold, which could be years in the future.
Executives benefit more from share repurchases, as the share price does not fall as it does with
dividends. This means their share options will be more valuable than if they paid a dividend.
Q4. It is said that the value of a share is the discounted value of all future dividends. Explain
why dividends are the basis for share valuation. How do you explain the value of
companies that pay no dividends?
Ans. The value of a share is the discounted value of all future dividends. Dividends are the cash
that companies return to shareholders. A shareholder buying a share might reasonably expect
their return in the first year to be a dividend and a capital gain. If they intended to sell at the end
of the first year the subsequent purchaser would expect a dividend and a capital gain at the end
of their holding period; the shares are subsequently sold and the process continues. If we look at
this from the point of view of the present time, the end selling price disappears and we are left
with the future dividends as the basis for the value of the shares. Each person in the chain expects
dividends and sells it on to someone who has the expectation of future dividends. The value of
the company depends on the amounts of cash that the company is expected to pay to the
shareholders, not upon what the shareholders are expected to pay each other when they buy and
sell shares.
For companies that don’t pay dividends, they would have no value if this was expected to continue
forever. The expectation is that one day they will start paying dividends. In the interim the
company will be valued on the free cash flows it generates. The company would presumably be
growing very fast during this phase. At some stage the company’s growth will slow, as the impact
of competition eats into the growth rate. Once the fast growth phase is over, the shares will come
under downward pressure and may need dividend payments to support the stock.
Q5.Some social media companies have price/earnings ratios in the hundreds, while
traditional industries and even Apple have price/earnings ratios in the low teens. The
price/earnings ratio is one of the most commonly used methods of valuing companies.
Discuss the strengths and weaknesses of the price/earnings ratio, comment on the range
of P/Es highlighted above and identify when it would not be correct to use the P/E ratio.
Ans. Stocks of companies such as LinkedIn, Amazon and Facebook have traded on P/E ratios of
over 100 for long periods of time, while most of the rest of the stock market trades with a P/E in
the teens. Why is this? The market is willing to pay fantastic prices for these stocks because they
think that they offer very fast growth rates far into the future and these P/E ratios will drop as the

vast surge of profits pours from these companies. Existing companies cannot offer this growth
potential, although Apple’s P/E ratio always seemed too low, given the growth rates it has
achieved.
Because the price/earnings ratio is based on accounting data, it can be open to manipulation.
The price/earnings ratio should only be used to compare companies within the same sector that
use the same accounting conventions. The ratio does not work well across sectors, and if the
accounting conventions are different between companies this can give rise to inaccurate
valuations. Within sectors with the same accounting conventions, the P/E can be used to gauge
how a company is doing relative to its rivals.
Different companies may have the same P/E ratio but be at different stages in their development:
one may be a new, growing company; another may be one whose profitability has fallen and has
reached maturity.
A company may have a very high P/E ratio but be in a very weak position, due to the fact that
profits have collapsed while the share price has not fallen accordingly. The market here may be
viewing the profit drop as being very temporary, or it might be that the company is now a takeover
target.
The P/E ratio is dependent on the share price being correctly priced, which may not always be
the case for a large number of reasons.
Past Paper June-2017
Q1.Discuss how you analyse the decision to lease or buy an asset.
Ans. The lease or buy decision is another capital budgeting problem. What is being done is to
work out the present value of the lease cash flows and set these against the cost of actually
buying the asset.
In doing the lease analysis you are looking at the decision from the point of view of leasing. So
the price of the asset is like a cash inflow; it is money that is not being spent. The depreciation
tax shields that go with the purchase cannot then be claimed, so they are effectively an outflow;
the lease payment itself is a cash outflow; and the tax benefit from the lease payment is something
you do receive, so that is a cash inflow. The operating cash flows that come with the asset are
irrelevant, as they would be the same whether it was purchased or leased.
The lease effectively displaces debt, as debt would be used to finance the purchase, so the
discount rate used is the after-tax cost of debt.
The cash flows are netted off and discounted. If there is a positive value this means there is a net
advantage to leasing. The value of not buying the machine is greater than the present value of
the lease cash flows. And vice versa.
A complicating factor would be the salvage value of the asset. This would effectively be a cash
outflow to the lessee, as they cannot claim this, as they do not own the asset. The salvage value
goes to the lessor. The discount rate on the salvage value would be the company WACC, not the
after-tax cost of debt, because the salvage value is a risky cash flow.
Q2.Describe the different methods of depreciation and explain what impact they will have
on the NPV of a project.

Ans. There are three main methods outlined in the text: the double declining balance, the sum of
the digits, and straight line methods.
The straight line method allows a constant rate of depreciation each year. For example, a machine
costs £400,000 and is depreciated straight line to zero over five years. This means that
depreciation each year will be £80,000. At the end of five years the asset will have zero book
value.
The double declining balance method means that depreciation occurs at twice the rate of the
straight line method. In the above straight line example, depreciation for each of the five years
was 1/5 of the asset’s cost; with double declining, 2/5 depreciation is taken off in the first year,
then in the second year 2/5 of the remaining depreciation base is taken off. And so on, so that at
the end of the depreciation period under this method, the depreciation allowance will be much
smaller than the straight line depreciation.
The third method is the sum of digits method. This allows a deduction equal to the proportion
found by dividing the remaining depreciable life of the asset by the sum of the years of the asset’s
total life.
Under each of the methods the actual total amount of depreciation will be the same, but in present
value terms it will be different. The accelerated depreciation in double declining balance will give
a higher present value of the tax shield than the other methods, so companies would want as
rapid a depreciation schedule as possible.
Q3. If a firm is said to have very high operational gearing, what does this mean and how
might a company lower its operational gearing?
Ans. A company is said to have high operational gearing if it has a high level of fixed costs in its
operations. This may be very high investment in machinery, or factories, vehicles, offices, the
depreciation on machinery, or the rent on offices. What this means for the company is that it needs
to generate relatively high cash flows to cover the fixed costs. This makes the company riskier,
as there is a greater chance that it may not have sufficient cash flows.
It is difficult to reduce fixed costs, but the costs could be made less fixed, perhaps by contracting
out some operations. Fixed costs are part of the basic business and they are hard to cut back.
The company could move away from a particular line of business into areas where there was not
so much dependence on fixed costs.
Q4.Explain when you would be likely to use (i) options, (ii) forwards, (iii) futures, and (iv)
swaps. Clearly differentiate as to where you would use each particular product and explain
why that product is suited to that situation.
Ans. i) Options are insurance products: you pay a premium for protection. If the bad event
happens, you are protected. If the underlying moves favourably for you, you do not need to fulfil
the option contract – you can take advantage of the good move. An example would be taking out
a foreign exchange option which protects you against a fall in the dollar. If the dollar goes up, an
option allows you to take advantage of that move.
(ii) Forwards are tailor-made terminal products. They do not require any up-front premium. They
are settled at expiry with the selling bank. They are most suited to smaller companies, to markets

that may not have coverage in the futures market. They do not require any cash flows before
expiry, unlike futures where you may have intermediate cash flows.
(iii) Futures are exchange-traded derivatives. They require an up-front margin payment and often
further payments during the life of the contract. The product is standardised and there is no credit
risk. Entry into the market is quick and usually anonymous. A fund manager could use the futures
market to gain access to the stock market if he or she wanted to invest but was still waiting for
funds to come through. The futures purchase involves a fractional payment for exposure to the
underlying asset.
(iv) Swaps are like a series of forward contracts without the need to continually renew the contract.
Companies will use swaps to try to achieve a lower cost of borrowing in either the fixed or floating
market. Currency swaps can also be used where you borrow at reasonable terms in your home
market, then arrange a swap into the foreign currency at a much better rate than if you borrowed
directly from that foreign market.
Q5.Draw and clearly label the payoff diagram for a seller of a put option.
Ans. The payoff diagram for a put seller is shown below:
The lower of the two diagrams is the one for the seller of a put option; the top diagram is the
payoff for the buyer of a put option.
Q5.Identify the five variables that go into the Black–Scholes option pricing model. Explain
how movements in these variables affect the price of a put option, and what is meant by
put–call parity.
Ans. The five variables are: share price, exercise price, interest rate, time to expiry and volatility.
A put option gives the holder the right to sell an asset at a fixed price (the exercise price) up until
a set date.
The put price will rise as the share price falls (S0); the right to sell at the higher fixed price will
become more valuable. The put price will rise as volatility (v) and time (t) to expiry increase. With

volatility, the holder is only exposed to downward volatility, as the maximum they can lose is the
price paid for the option. The put will have a higher value if there is more time to expiry; there is
more time for the asset to fall in value. The put price will rise as the exercise price rises (X). This
follows from the general pricing relationship for puts: X – S0. The put price will fall as the interest
rate (r) rises, because you are effectively delaying the sale (and receipt of funds that would earn
interest).
Put–call parity is the relationship that means if you can price the call option using the variables
above, then the put price can be obtained by using this relationship:
Put value = Call price + Present Value of Exercise Price – Stock price
The put value can be calculated using the Black–Scholes or binomial pricing models, but if you
have the call price, the exercise price, the stock price and the risk-free rate of interest, you can
obtain the put price more easily.
Past Paper Dec-2016
Q1.You make a mistake in estimating the NPV of a project. You have discounted the net
income rather than the cash flows to the project. Would you expect the NPV that you have
calculated to be higher or lower than the NPV using cash flows? Explain why there is a
difference.
Ans. If you discount the net income by the WACC, you may well end up with a negative NPV. Net
income is not the same as cash flows. The net income has had depreciation subtracted in its
calculation. Depreciation is not a cash flow. So to get towards a cash flow figure, you have to add
depreciation back on. Therefore cash flow can be a higher figure than net income. But that is not
the whole picture. Net income only gives one side of the story of the company; it does not say
what the capital expenditure has been or anything about the level of working capital investment.
These are reflected in the cash flows, and they are also reflected in the balance sheet. You could
have a company with large capital expenditure requirements, which could mean there is very little
free cash flow being generated. In that case, the net income would probably be higher than the
free cash flows. This could also depend on how the assets are being depreciated.
To answer the question, then: it depends on the type of company. If there are large capital
expenditures, net income may be larger than the free cash flows. If the company is more mature
and not spending much on capital, the cash flows may be higher than net income.
Q2. When a firm is faced with a capital rationing situation, how can the profitability index
be used to select the most attractive projects for the firm? Explain why choosing projects
with the highest profitability index might not always lead to the best decision.
Ans. Capital rationing is a situation where a company is not able to undertake all the projects it
would like to. There is a capital constraint: it doesn’t have enough cash for all the projects. So
which projects does it select? The profitability index method will rank projects on an NPV per £ of
investment basis. So the top-ranked project will produce the most NPV per £ of capital spend.
The rest of the projects will be ranked in descending order. The company then chooses the first
project, then the second and so on until the budget has been used up.
But this might not lead to the maximum NPV for the firm. By selecting according to strict ranking,
it may have some money left over, because the next project on the list costs more than the amount

left in the budget. The surplus cash will earn zero NPV. What the company should do is select
the mix of projects that will maximise the NPV for the firm. So the firm needs the PI ranking and
the NPV for each project: then it can select the mix of projects that would use up the budget and
maximise the NPV.
Q3.The standard deviation on a portfolio is typically less than the weighted average of the
standard deviations of the shares in the portfolio. Why is this? Explain why a portfolio’s
beta is the weighted average of the betas of the shares in the portfolio.
Ans. The standard deviation of a portfolio of shares is not the weighted average of the component
standard deviations because of the diversification effect. For the standard deviation to be the
weighted average of the components, the correlation between the shares would have to be perfect
(i.e. +1.0). This does not happen, so by combining shares in a portfolio, the risk is reduced. With
different shares from different sectors, there will be different reactions to economic factors.
Diversification eliminates specific risk (or unique risk), but it does not eliminate market risk. Beta
measures the market risk (or systematic risk) of a share. So for the beta of a portfolio, it is the
weighted average of the component betas.
Q4. Some multinational companies do not hedge. What arguments would you give for this
position?
Ans. Companies that do not hedge are in effect speculating on what the actual exchange rate will
be when they settle their business transactions. By hedging they remove any uncertainty over
what the exchange rate might be. They lock in a rate that they have to take whether there has
been a favourable or unfavourable move in the underlying exchange rate.
However, some companies do not hedge. These may be large multinationals that have numerous
operations in many different countries. The operations that they have may be well diversified, so
that by hedging they would actually incur further costs for not much benefit. Some companies
may hedge up to a certain level in the exchange rate, saying that to hedge at beyond these rates
does not make economic sense. This may be so with the dollar/euro rate where the euro has
risen to the highest point ever against the dollar. Companies here may take the view that the
currency cannot rise further and to hedge would be a waste of money. If the euro then fell and
the company had hedged, it would be locked in at an unfavourable rate and its rivals that did not
hedge would have a comparative advantage.
Q5. Companies face translations risk and transaction risk in international business. What
are they and how should they be hedged?
Ans. Translation risk is an accounting risk. It is the risk to earnings on the translation of foreign
revenues into the domestic currency. Because it is an accounting procedure, it is a paper figure
and it may not reflect the actual underlying position of the company. The figures will usually be
drawn up on the basis of the exchange rate at the year end.
Translation risk is not as important as the other foreign exchange risks. Most companies do not
hedge translation risk. The impact of not managing translation risk is that the accounting figures
may be slightly more variable, but to manage this would cost the company a significant amount
of cash.

Transaction risk is the risk that the exchange rate will move between the time of agreeing a
business transaction and the time of cash settlement of the deal. For example, a UK company
might agree to sell goods to a customer in India on 1 August, with settlement on 1 November.
The Indian will pay in rupees, but the danger is that the rate that held on 1 August will not be the
same as that on 1 November. If the rupee weakens, the UK exporter will receive less sterling
when the rupees are converted to sterling. To guard against that, the exporter will take out a
forward exchange contract, which will lock in a fixed exchange rate. Futures on the Indian
currency are not available yet, but it is anticipated that there will be a rupee futures market soon.
Q6. Draw and clearly label the payoff diagram for a seller of a call option and explain when
the seller will profit and when they will lose on the transaction.
Ans. The call seller payoff diagram is shown below. The call seller’s gain is capped when they
enter the transaction. The losses are potentially unlimited. The seller of the call option has a
negative outlook on the underlying share (or commodity or whatever market the option
represents). If the share price falls, the option seller keeps the premium (the horizontal line above
the x-axis). If the share price rises, the option seller faces potentially serious losses. The option
price at expiry is dictated by the relationship Share price - Exercise price.

Q1. Why is inflation a problem in capital budgeting and how should it be dealt with? Give
an example of the problems inflation can cause in capital budgeting.
Ans. It is usual with capital budgeting to discount nominal cash flows with a nominal discount rate.
Nominal means that the figure includes inflation. The alternative is to use a real discount rate on
real cash flows. This means that inflation has been excluded from the calculation. Nominal is the
norm. The cost of capital quoted by companies in their annual reports is a nominal rate, so the
cash flows projected for projects should be nominal as well.
Failure to adhere to this convention could lead to errors being made in project selection. For
example, if a company were to use a nominal discount rate on real cash flows, the NPV would be
understated, because the cash flows are not high enough: they do not include inflation, as the
discount rate does. So the company is in danger of rejecting a good project as a bad project.

It is therefore important for the finance department to make sure that nominal cash flows are being
discounted by a nominal discount rate.
Another capital budgeting problem in countries with higher inflation is treatment of depreciation.
If you have an asset being depreciated straight line over 10 years and there is relatively high
inflation, say 10% or above, then the real value of the depreciation tax shield is falling each year.
This could discourage investment.
Q2. Discuss the tax impact on NPV if the management at GSA decided to reclassify the
equipment as three-year equipment rather than five-year equipment. No calculations are
required.
Ans. Depreciation creates a tax shield for a firm. If you have an asset worth £100,000 and it is
being depreciated straight line over five years, this would result in a depreciation charge of
£20,000 per year and a depreciation tax shield of £6,000, using a tax rate of 30%. If the asset
was depreciated over three years rather than five, then the annual depreciation charge would be
£33,333 and the depreciation tax shield would be £10,000 per year. This is a substantially higher
tax benefit than with five-year depreciation. The impact on the NPV would be to increase the NPV,
as the tax charge will be lower and the tax benefit is being delivered over an earlier time period.
Managers would wish to depreciate assets as quickly as possible to maximise the present value
benefit of the tax shields.
Q3. Discuss the ways in which taxation will impact on a company’s payout decision.
Ans. The dividend decision is irrelevant when there are perfect markets; it works less well when
there are market frictions. One of these is taxation. Taxation will impact on dividend decisions in
different ways in different countries depending on the tax regime. Debt has a tax benefit in the tax
deductibility of interest payments. Dividends have no such deduction, and in some countries the
dividend is taxed twice: once on the company’s profits, and then again when the shareholder
receives it. In those countries there would be an incentive not to pay large dividends as it would
not be in shareholder interests. The US was like this up until the tax reforms of 2003. A
consequence of this is that since the end of the 1990s companies have been buying back (share
repurchases) more shares in value terms than they were paying out in dividends. The dividend
faces tax immediately; with the share repurchase the tax is deferred to a later date.
Some countries work on an imputation system, whereby the dividend is only taxed once, so there
is less bias against dividends.
The aim of the company is to maximise the wealth of their shareholders and if that means
returning cash to them in ways other than dividend payments because of the tax environment
then that is what they should do. Many companies return cash via both the dividend and share
repurchase, with the latter making up more of the distribution.
Q4. Excluding taxation, identify and discuss four key factors that would have an influence
on the dividend decision by a company. How would each of these factors influence the
dividend decision?
Ans. Among the factors that might be cited are: level of gearing; capital expenditure requirements;
growth and profitability trends; what other companies in the sector are paying out; ability, ease
and expense of raising new capital (both debt and equity); and control issues.

Gearing is an influence because debt service comes before any payments to shareholders, so
the company must consider its level of interest cover through a business cycle when setting a
dividend policy. Capex requirements also have an impact. If capex is lumpy, there may be
problems over the dividend or capex, possibly resulting in a share sale, the timing of which might
not be perfect. The future trends in growth and profitability will have a strong influence on the
dividend. If the company is in a highly competitive sector, where there is sales growth but price
deflation, this could put the dividend under pressure. There will be a payout rate for the sector
which will be regarded as a level that is sustainable, given the nature of the business, so the level
of rival companies’ dividends will be a factor. By paying out large dividends there will be a greater
chance of the company having to sell more equity to raise cash. This would dilute their stake: the
implication is to pay low dividends and make sure you have enough cash to finance the business.
The control factor will be an issue if there is a dominant shareholder who wants to maintain his
grip on the company.
Q5.Discuss whether share repurchases are a good use of company cash. Explain why
some directors sell shares while at the same time they decide the company should buy-
back shares.
Ans. The price paid in repurchases is important. If managers buy in shares at what turns out to
be very high prices (the shares subsequently fall in value), it will be seen as a waste of
shareholders’ cash. There are plenty of examples of companies which have bought back shares
only to see the stock price fall substantially in the months afterwards. Managers at companies do
not have a good record of timing their buybacks. Rather than buying back the shares when they
were low, the peak of share buybacks was as the stock market peaked. The stocks then declined
and the implied return on these purchases was very poor. If those had been presented as the
returns on a conventional investment project, the board would have rejected it straight away.
This represents a poor use of company cash. If companies are buying back shares it may mean
they are not investing for the future growth of the company.
If the managers announce a share buyback programme, but at the same time they are selling
their own shares, this sends a poor signal to the markets. If the bosses announce a buyback,
using shareholders’ money, they should really support that decision with their own purchases. If
they are selling their shares, they are in effect saying the shares are overvalued, which
undermines the validity of the buyback.
Shareholders will lose out if shares are bought at levels higher than their intrinsic worth. Managers
should know the value of their company and refrain from value-destroying buybacks.
Past Paper Dec-2015
Q1. What is the recommendation based on return on the initial investment? How can
companies manipulate this method?
Ans. The return on investment is average profits divided by the investment in the project. The
return on investment is a weak method because it uses accounting profits, which can be
manipulated to give a more attractive picture. There are a number of ways of calculating return
on investment. Another version would have average investment as the denominator. This would
be the initial investment plus the salvage value, all divided by 2. Return on investment is a poor
method because the company can cut back on investment to make the return more attractive.

Companies can take write-offs to reduce the amount they have invested, which makes future
returns look better.
It does not include all the relevant cash flows in its calculation.
Q2. Write a short report highlighting why the Net present value is superior to return on
investment.
Ans.Net present value is superior to return on investment or any accounting measure, because
NPV considers risk in the analysis. Accounting measures do not consider risk. The accounting
measures treat each year of profits as having the same weight, so the weight on the first year’s
profits will be the same as the weight on the fifth year’s profits. With NPV, the cash flows are risk-
weighted.
NPV focuses on cash flows, whereas accounting profits do not represent cash flow. Accounting
profits contain non-cash items, such as depreciation, which means the company can be reporting
profits, but actually have a poor cash position. This is highlighted in the fact that the net income
statement does not include capital expenditure or net working capital.
With NPV a cost of capital can be calculated for the company that reflects the risk of the
investments it is undertaking. On completion, the NPV analysis will show the wealth that will be
created or destroyed by the project. The accounting measures give an unrealistic picture of the
return generated by the project.
Q3.Explain how you would treat each of the following in the capital budgeting process:
cannibalisation, sunk costs. Give examples of each.
Ans. Cannibalisation is where the introduction of a new service or product steals sales away from
the existing range of products. This impact will be treated as a negative cash flow in capital
budgeting, unless the company finds itself in a very competitive marketplace and failure to
introduce the new service or product would have led to a fall-off in sales anyway because rival
companies would have introduced new services or products.
A recent example cited in the UK was Tesco. Tesco has seen sales fall and the company has
experienced problems at their large hypermarket stores. Over the five years to 2014, Tesco
opened more and more convenience stores (small stores in city centres) and not so many giant
hypermarket stores. The public had been shopping more at the small stores and less at the big
stores. The small stores were not very profitable. The accusation was made that Tesco had been
cannibalising sales with the introduction of the small city centre stores. But if they had not made
this move they would have left that market open to their rival companies. Sainsbury’s and others
had been opening these small stores as well.
So cannibalisation is more complex than just saying a new product will steal sales from older
products. That is certainly the case if there is little market pressure on the company.
Sunk costs are costs that have been incurred in the past; the cash has been spent and that cost
is irrelevant as far as the cash flows are concerned, unless they give rise to an opportunity cost.
A sunk cost might be a building that belongs to the company. It has been paid for and that cost is
sunk, but that does not mean it is free to the project. If the asset has alternative uses, these give
rise to opportunity costs, which have to be considered. These would be cash outflows.

Q4. Discuss why capital rationing might occur and clearly explain how a company would
choose among a number of projects and a limited budget.
Ans. Capital rationing is the situation where a company does not have enough funds to fund the
projects available to it.
In the financial markets a situation like this should not exist. If a company identifies good positive
NPV projects, the financial markets should be prepared to fund them because there is wealth
being created.
Two types of rationing may exist, soft and hard rationing. Soft capital rationing is where the
company itself puts a limit on the number of projects it will do. There may be competing divisions
within the organisation. A cash limit (budget) may be put on the division, or the divisions will have
the discount rate increased. The company may add, say, 3% to the discount rate to evaluate
divisional projects.
Hard rationing is where the capital markets are not willing to fund the company’s projects. This
may apply more to smaller high-risk firms. The markets are not sure of the information coming
out of the company, so the discount rate offered for funds becomes too high for the project to
work. Better information and a good track record of successful projects will lead to an easing of
this problem.
If a company is looking to select projects among divisions they should use the NPV technique to
work out the maximum NPV that can be earned from the cash available. It would not be a case
of just taking the projects with the highest profitability index values, but the mix that generated the
highest NPV.
Q5. Why would a company issue a zero-coupon bond? What is the attraction of a zero-
coupon bond to an investor?
Ans. A zero-coupon bond pays no interest during its life. There is only one cash flow and that is
at maturity. The bond will originally be issued at a discount to the face value, so if the face value
is £100 and a company issues a five-year zero-coupon bond and they would like it to effectively
yield 5%, the bond will be sold at:
£100/(1.05)P5 = £78.35
The investor will buy the bond at £78.35 and if they hold it for five years, the company will buy it
back for £100. The investor will have made an average return of 5%, but the return will be paid
as a capital gain, rather than income. Capital gains will usually attract lower tax rates, so higher-
rate taxpayers will be attracted to zero-coupon bonds.
A company might issue a zero-coupon bond because there might be no cash flows coming in
from a project for a number of years. The zero-coupon bond means they will have no debt service
during that time. For example, a company might be building a toll road and the cash flows from
the project won’t start flowing for maybe four or five years. This type of bond means they don’t
need to worry about debt service while the build stage is undertaken. When the bond matures it
can be refinanced with a coupon-paying bond, which will be serviced by the cash flows from the
completed toll road.

Q1.Companies often face a decision over whether to ‘make or buy’, i.e. whether they
manufacture an item themselves or whether they buy it in. How would you analyse this
decision and what non-quantifiable factors would you also take into account?
Ans. With a ‘make or buy’ decision you need to work out the present value of the costs of
manufacturing, including all relevant incremental cash flows, particularly looking at any
opportunity costs and compare that against the cost of buying. An opportunity cost might be
having to use space that might be currently rented out and bringing in income. Subtract the cost
of making from the cost of buying and calculate the present value the incremental cash flows. If
the NPV is negative, continue buying; if positive, then manufacture.
Other factors to take into account would be, say the company is manufacturing at the current time,
by switching to buying in, they may be taking a risk. Can they be sure of receiving all the supplies
they need all the time? It can be more convenient to manufacture since the supplies are always
at hand. If you ceased manufacture, there may be trouble with the morale of the workforce as
some would have to leave the company.
Q2. A company, Eastways has a large unused office space at the moment. In capital
budgeting terms, discuss whether this is a sunk cost or an opportunity cost.
Ans. The office building can be both a sunk cost and an opportunity cost. It is a sunk cost because
the money has already been spent on it. That money has gone. So in that sense it is irrelevant to
the cash flow analysis. However, the office building will have a value, whether from an outright
sale or through renting out. The opportunity cost is the most valuable of these two options. This
opportunity cost would then be a charge against a future project using the office building as part
of the project.
Q3. Discuss the problems in estimating a cost of equity for a company.
Ans. The cost of equity can be calculated using the CAPM or the dividend growth model. With the
CAPM we need the risk free rate and the market risk premium, and the beta of the stock. The risk
free rate will be the interest rate from the government bond curve for the length of the project. The
market risk premium is the extra return earned for investing in equities rather than government
bonds, usually around 6%. The real problems are with the beta. The beta is the regression
between the stock return against the market return, taken over a five year period. This is assumed
to be stable, but what happens if the company changes its make up during that time, then the
beta will not be accurate, e.g. the company makes a takeover, or it divests a major asset.
Similarly with the dividend growth model (DGM) there are problems of stability. The key input into
the DGM is the growth rate of dividends. But what time period to take? The company may try and
convince investors that the period that corresponds to the fastest growth should be taken (this will
result in the highest value for the company). But is that time span for dividends really reflective of
the company now? It is similar to the CAPM. Has something happened that changes the nature
of the firm? The DGM is very sensitive to the growth rate fed into it.
Q4. What types of covenants are usual in debt contracts? Explain the role they play in debt
and equity financing.
Ans. Covenants are placed in bond contracts to try and overcome some of the agency problems
between bondholders, on the one side, and managers and shareholders, on the other side.
Managers work for the shareholders, they have a duty to maximise shareholders wealth.

Bondholders are suspicious that managers will do this at their expense. One way would be to say
to bondholders, ‘We want to borrow £100m and we are going to use it for low risk investment in
keeping our assets in a good sellable condition’ (e.g. a retail portfolio, investing in the appearance
of the retail portfolio). But after receiving the cash from the bondholders, the managers decide to
invest in a risky overseas project. If the bondholders had known about this they would not have
given them the money, or if they had it would be at a much higher interest rate.
So bondholders put restrictions on the use of the cash. They put restrictions on the amount of
dividends that can be paid out (paying out large dividends reduces the amount of cash available
to pay debt interest and capital). There are restrictions on the seniority of new debt that can be
issued (the current debt holders do not want to be knocked down the ranking to be repaid). The
company may be required to pay cash into a sinking fund that would be used to redeem the bond
(this gives reassurance to the bondholders that the principle will be repaid).
There are positive covenants as well, where the company is required to maintain certain financial
ratios above prescribed levels, e.g. earnings would be required to be a minimum multiple of the
interest charge, certain levels of working capital need to be maintained.
The role of the covenants is to reduce the agency conflict between bondholders and managers
shareholders.
Q5. Why might measures based on EBIT (earnings before interest and taxes) or EBITDA
be more useful than the price earnings ratio as bases for valuing companies (i.e. market
capitalisation/ earnings, or total company value/EBIT)? What might be the disadvantages
of using EBIT or EBITDA?
Ans. EBIT are earnings before interest and taxes, EBITDA are earnings before interest, taxes,
depreciation and amortisation. They are used extensively to value companies. A popular
shorthand for valuing companies is the price-earnings ratio (P/E ratio). The earnings in the P/E
ratio is net income, or after tax earnings. It has had everything taken off. Similar companies in the
same sector may have different capital structures, one company may have no debt and another
company 50% debt finance. These two companies will report vastly different net income figures,
because of the interest deduction before tax for the geared company. This means that the P/E
form of valuation would be inappropriate in this case. The P/E ratio does not adjust for gearing
effects.
Valuations using EBIT or EBITDA remove the gearing impact, because the earnings figure used
is before the interest is taken off. This means that the companies can be better compared for how
they are performing on an operational basis. If the EBITDA measure is used, this takes earnings
before the impact of capital expenditure is felt, i.e. before depreciation is subtracted.
But if you are taking earnings back this far to establish values, you have to ask, what is it that
creates value for a company? It is investment, it is capital expenditure on good investment
projects. So to exclude capex like this would be to fail to recognise the investments that might be
needed to create value for companies.
EBIT is useful because it still reflects capex requirements, but removes the impact of gearing.
Q6.What are the direct and indirect costs of financial distress? Which has more impact on
the value of the company and can you discuss the nature of these costs and how they

affect the company, giving examples where possible? How can the company get out of
financial distress?
Ans. Direct costs of financial distress are the bankers, court and lawyers fees involved in the
process. These costs are relatively minor compared to the indirect costs of financial distress. The
indirect costs are the costs that are felt most heavily by the shareholder. If a company is in
financial distress, the share price will be falling, the company will have to be cutting back on
operations. Workers will be in the process of being laid off, capital expenditure will be frozen,
which means the company will not be able to take on good projects for the future. The dividend
will be cut to preserve cash, to try and pay off some of the debt. The managers will be spending
most of their time fighting the distress, rather than running the company normally. Rival
companies are likely to make it difficult for the distressed company; they could launch price wars,
or poach the key staff from the weakened company. To try and raise cash, the company may try
and sell assets. They are unlikely to get a fair value for these assets, being a forced seller.
Suppliers become unwilling to provide goods other than for cash settlement.
To get out of financial distress, the company has to try and preserve cash if it can. The dividend
is cut, capex is frozen, factories, offices are closed down, workers are laid off, and divisions are
sold if they can raise a decent price. The company may be forced into an emergency equity issue
(although this will be at a low price which will dilute existing shareholders). If the company has
reasonable prospects of survival, a convertible bond might be able to be issued.
Examples of companies in financial distress range from Sweden’s Ericsson in 2001 – 2003, in the
last recession, to Dixons, Yell, Barratt, ITV, HMV, Punch, among many others in the UK since the
2008 credit crunch.
Past Paper Dec-2014
Q1. Why would you not use accounting profit as the basis for project attractiveness?
Explain how you would extract the free cash flows necessary for an NPV analysis if you
were given a set of accounts (i.e. a profit and loss statement and a balance sheet).
Ans. Accounting profits does not represent cash flows. Accounting profit contains non-cash items,
such as depreciation, and apportionment of items. The P&L excludes investment in working
capital and capital expenditure. So they do not give a true picture of the company.
To extract cash flows from a set of accounts, you first need operating profits, then add any change
in capital expenditure (figures from B/S, any sale of assets will be in P&L; a figure negative for an
increase in capex), then add any change in net working capital (again from B/S, and again a
negative for an increase in net working capital), then you need to subtract the interest tax shield
(interest payments from the P&L), then subtract tax. This will give you free cash flows for
discounting purposes.
Q2. Explain the concept of beta measures and how would you estimate a beta value for a
share?
Ans. Beta measures the amount of market risk contained in a share. This is the amount of co-
movement the share will make with the market. A share with a beta of 1.2 would be expected to
move by 1.2 times the market index. This is the systematic risk of a share. It is not the total risk
of a share. The share will also contain specific risk.

Beta is measured by taking a plot of the stock price return against the return of the index, usually
over a period of 60 months. A regression is run and the beta is the slope of the regression line.
Q3.Explain what the following terms mean in relation to options:
(i) Out of the money
(ii) Exercise value
(iii) Put-call parity
Ans.
(i) Out of the money is when the stock price is lower than the exercise price, e.g. exercise price
= 200p and the stock price is lower, say 190p. This means that the option will have no intrinsic
value, i.e. S0 – X is negative. Option prices get lower the further out of the money they go.
(ii) Exercise value is the value that is realised when you exercise the option, i.e. if you have a call
option, you are opting to purchase the underlying asset. The formula for calculating the exercise
value is S0 – X. If this is positive, the option is in the money. But by exercising you will lose the
exercise value, e.g. exercise price is 200p and the share price is 205p and the option price is 10p.
If you exercised your call you would be buying shares at 200p, when they are 205p in the market,
but you would be giving up the 10p option value, so you would lose 5p on the transaction.
(iii) Put call parity is the relationship between the put and call prices and the exercise price and
the stock price. A package of the put and the stock price will have the same payoff as a package
of the call and the present value of the exercise price. With this relationship, the put price can be
obtained once the call price has been calculated.
Q1. Write a note to the CEO outlining your objections and explaining why you feel that NPV
is the superior method to Average accounting rate of return (AARR).
Ans. Average accounting rate of return (AARR) is a poor evaluation technique. It uses the wrong
figures, accounting numbers, rather than cash flows. The accounting profits are not the same as
cash flows. They have non-cash items included, and exclude changes in net working capital and
capital expenditure. So AARR gives a misleading picture of the company performance. The
measure does not build in risk to the analysis; each profits figure has the same weight as the
previous one, i.e. there is no time value. NPV corrects these errors, it discounts, and it uses cash
flows. It shows the wealth created for shareholders.
Q2. Real options can be used to evaluate the abandonment decision. Describe how you
would do this.
Ans. Abandonment suggests the project has not gone as well as expected. Abandonment is the
option to walk away. Abandonment options can be valuable because a firm can ditch a project if
it disappoints.
The project could be liquidated at various points during its life. The liquidation value would be the
exercise price (X) and the present value of the project would be the asset value (S0 in options
terminology). If X is greater than S0, then the project should be liquidated, whereas if S0 is greater
than X, the project still has positive value.

By shutting down the project, Pomona would be saving money that would otherwise be lost if the
project was kept going. The amount saved represents the gain from exercising the abandonment
option.
Q3. If the project went well and Pomona decided to sell it, how would a potential buyer
value the project? Compare cash flow valuations against earnings valuations. What are
the dangers in each method?
Ans. If the project was successful and another company was interested in buying it, they would
best value it using a discounted cash flow valuation. They would forecast cash flows going into
the future and a growth rate of those cash flows. They would then use the dividend growth model,
but instead of dividends being discounted, it would be cash flows. A discounted cash flow
valuation is better than using an earnings multiple valuation. It uses cash flows rather than
accounting figures, but the DCF valuation can be manipulated as well. By altering the growth rate
of cash flows on the top line, or altering the discount rate on the bottom line, you can greatly
change the valuation figure.
Earnings figure valuations depend on different companies using the same accounting
conventions. Accounting earnings do not give a true picture of the cash flow position of the firm.
The p/e ratio for a particular sector can be over-valued by the market, leading to unrealistic
valuations.
Q4.Biotechnology firms usually have very low levels of gearing, what reasons can you give
for that? They also have high betas, why would this be?
Ans. Biotechnology firms are risky, because they have to discover new drugs to be successful.
The drugs have to go through years of testing before they come to the market and they can fail
at any time during the process. The firm does not know when a drug might fail. In a sense, it is a
random event. If the firm had a lot of debt funding, the failure of a drug in the testing stages would
put off the point where the firm generates free cash flows. So biotech firms have low levels of debt
because they cannot be certain about their cash flows. Equity funding gives them extra flexibility.
The biotech firms also have high betas, despite the low debt levels, and this is because of the
business risk they face. They usually do not have a full pipeline of new products about to come
on to the market. They are not diversified, and their sector is risky. If they are successful with a
new drug, then the earnings stream from that can be huge and the share price will soar, but a
drug failure or withdrawal, means that the market will remove those potential cash flows from the
valuation and the stock price plummets.
Q5. Working capital management is an important part of running a company and its
importance is often overlooked. Why do companies hold cash balances and how would
they manage their cash balances in an effective manner?
Ans. Companies hold cash for three basic reasons: for transactions uses; to pay debts as they
might arise; and for other day-to-day needs. For precautionary uses, there may be unexpected
events that demand action from the company and require cash. It may be that the company
suddenly loses a lucrative contract and they need cash flow to keep the company functioning.
Compensating balances are required at banks. These minimum balances are kept at banks at
very low rates of interest as a requirement of the bank for them to perform functions for the firm.

The firm will want to manage its cash balances to maximise the return it generates from its cash.
They will not want to keep any more than is necessary in the compensating balances at the bank,
instead they will want to keep the remainder of the cash in high interest accounts or marketable
securities that offer attractive returns.
The way the company can manage this is to use a simple economic order quantity model
(Baumol’s model), which will determine the minimum amounts of cash to hold, how much to put
in to replenish the cash, done in a way to minimise the cost each time of so doing.
The aim of this is to allow the company to maximise its return on its cash, while having adequate
cash on hand to manage the business.
Q6. Companies will hold varying levels of stock. Explain what the benefits and costs of
holding inventory are.
Ans. Inventory helps the firm maintain production of its goods. A lack of inventory might mean
that the production line has to stop and valuable finished goods would not make it to the market.
If the firm has too low an inventory, there will be a danger of stock outs and lost sales as a result.
The lost sales may go to rivals and be lost for good.
Holding inventory can also manage seasonal demand for goods. If the company maintains steady
production through the year and builds up to a peak of demand (say for the Christmas season),
this will mean that they can plan their production inputs more efficiently. However, rival firms may
opt for ramping up production nearer these demand peaks and hiring temporary staff to cope.
The costs of inventory are the actual costs of holding the stock during that time the firm is not
getting revenue from a sale. There are order costs and carrying costs associated with inventory.
In fact, an efficient stock order system is the same as the cash management model outlined in
part (1). By running very efficient inventory management systems, companies can free up large
amounts of capital that can be put to other use.
Q7.Companies need to extend credit to customers in order to generate sales. Explain how
a company efficiently manages its receivables.
Ans. Receivables are credit sales made by the company. So to begin with the firm needs to have
a credit policy. How much credit will they advance to their customers? How do they decide who
is a good customer and who is a bad customer? What credit terms do they offer? How do they
collect the receivables? How do they monitor and enforce their collection policy?
The company has to trade off between increased sales as a result of easier credit terms and
higher delinquency rates as a result of those easier credit terms. So some of the extra sales made
will not result in any revenue because the customer does not pay.
The company will conduct an NPV analysis of its credit policy. It will estimate the level of bad
debts that are associated with a particular credit policy. The analysis will compare the new policy
with the old policy, e.g. if the company decides to offer easier terms such as ‘net 30’, which would
mean that customers have to pay within 30 days of the sale. The selling firm has to finance these
credit sales, i.e. the cash might not be coming through for 30 days.
The result is the net benefit (or cost) in present value terms of the credit policy. This will tell the
company whether it makes economic sense to offer easier credit terms.

Q8. The UK supermarket retailer Tesco uses its payables as a means of financing its
business. Explain the methods a company would use to manage its payables.
Ans. Payables management relates to a firm taking up offers of credit. A firm may be offered credit
terms of, e.g. 2% discount if they pay within 30 days. What the firm should do is work out what
the implied interest rate is on the credit terms
If this interest rate is greater than the firm’s normal borrowing rate, then they should take the
discount.
This is trade credit. The firm should take the trade credit if it is the cheapest form of borrowing.
For some firms this bestows significant advantages. In the UK, Tesco usually has over £1 billion
of trade credit. Suppliers advance Tesco the goods; Tesco sells the goods and has put the cash
to other uses before it even has to pay for the original goods.
Some large firms do not take advantage of any discounts, but instead pay very late. Again they
will work out the implied interest on the late payment. In the UK this is a particular problem for
small firms doing business with much larger firms, who take months to settle their bills.
Past Paper Dec-2013
Q1. It has been said that APV is a better technique than WACC/NPV to use to evaluate
leveraged buyouts (LBOs) and management buyouts (MBOs). Why do you think this is,
and in what other corporate situations do you think APV would be superior to WACC (or
more useful)?
Ans. APV is more useful in these buyout situations because the initial deal usually involves the
buyout team taking on a large amount of debt to finance the deal. The aim of the private equity
company is to use the debt to take advantage of the interest tax shields to minimise the tax they
will pay, turn the company around, increasing profits and progressively reducing the debt over a
three to five year time frame. It would usually aim to float or sell the company at the end of that
period. The cash flows of the business will be used to pay down the debt. So with the buyouts the
capital structure will be changing each year. This is something that WACC finds difficult to deal
with. APV is designed to accommodate the changing levels of debt and build that into the analysis.
To use the WACC/NPV, you would have to recalculate the WACC for each year according to the
capital structure. With these types of deals the capital structure can be as high as 90% debt, which
is rapidly reduced over the following years. For the private equity firm, using the APV highlights
the present value benefit of the borrowing they are doing. APV is also very useful in isolating the
benefits of government subsidies and the costs of financial distress.
Q2. In recent years there has been considerable use made by companies of the convertible
bond. Discuss the reasons why companies have been using these bonds and what their
advantages and disadvantages are from shareholders point of view. Refer to recent
examples if possible.
Ans. Convertible bonds will usually carry a lower rate of interest than a normal bond issued by
the company. It has the attraction of being convertible into equity at some point in the future. The
conversion price will be set at a premium to the existing share price, maybe 40 - 50% above.
Recent issuance has been driven partly by distress level equity prices. In the past, when share
prices have fallen heavily and companies still have large capex programmes to fund, normal
equity and debt funding is too expensive. Selling new equity at those levels would incur massive

dilution, and the debt markets were charging huge spreads on straight debt for these types of
companies. The convertible sits in between the two; for the bondholder it offers a fixed return (the
coupon, although lower than on normal debt); for the shareholder, the company gets the funds
and can carry on with its capex programme and they don’t have to sell a mass of shares on to the
market.
The convertible, if converted, will be self liquidating. By converting, the bondholder is effectively
giving up the bond for equity and the company does not need to find money for redemption of the
bond. If, however, the share price goes down below the conversion price, the company will have
to redeem the bond. The advantage of the convertible to the company is that it is able, for
example, to refinance maturing debt with cheaper finance. It provides liquidity to the company at
low cost, it allows it to finance its business. The convertible allows the company to proceed with
projects that straight bondholders may have been unwilling to finance, feeling they were too risky.
The convertible helps ease the agency problems between parties in the company. The
disadvantages would be that the pricing may not be in the best interests of the shareholders; it
may be set relatively low and much of the future benefits would go to the bondholders. It may
create large dilution in the future, and the company would need to pay dividends on all the new
shares. There was massive convertible bond issuance in the early part of the last decade when
the national telecom companies got into trouble after the dotcom bubble burst. France Telecom,
Deutsche Telekom shares were trading at 10% of their previous values and equity sales then
would have been at distress levels and would have driven the shares down further. Straight debt
issues were too expensive. The convertible was the answer.
Q3. Conflicts of interest exist between managers and shareholders, but there also exists
agency problems between senior managers and middle managers within a company.
Discuss how you view this second set of agency problems and discuss the tools available
to resolve these problems.
Ans. Agency problems exist between managers and shareholders – failure by managers to act in
the best interests of shareholders, excessive consumption of company assets, failure to maximize
shareholder wealth by pursuing non-optimal courses of action. With senior and middle managers
there can also be agency problems. If the senior managers are assumed to be acting for the
shareholders, it may be the actions of the middle managers that are in conflict. The middle
managers may have their own pet projects that they want to pursue, which may not be wealth
maximizing. They may select projects that have negative NPVs, or they may window dress figures
to get approval. All of these actions will have a cumulative effect on the performance of the
company. A way to overcome these problems is to extend the packages that are offered to senior
managers and executives further down the organization to try and align interests of parties. So
options and shares should be granted to middle managers and long term incentive plans tied into
the performance of the middle managers.
Q4. Discuss two areas where information asymmetry is a problem in financial markets,
identifying the problems caused by it and the actions that can be taken to minimise the
effects of information asymmetry.
Ans. Information asymmetry is a problem in financial markets when (i) companies raise new
capital, and (ii) companies decide on the level of dividend payments. With raising capital, selling
debt or equity, the managers of the company will have more information than the lenders or the
buyers of equity. The ‘outsiders’ will be suspicious of the company and the ‘insiders’ in the

company, i.e. the managers. With equity issues the outsiders suspect that the managers are
selling them overpriced equity, and with bondholders there may be suspicions over what the
management will do with the money and the quality of the security offered. This is based on the
famous ‘market for lemons’ thesis developed by Akerlof. Bondholders can limit the problem by
placing restrictive covenants in the bond contracts, certain financial ratios have to be maintained,
limits on dividend payouts, etc. They can also put provisions in the bond, where they can force
the company to redeem the bond if it falls below a certain value. Bondholders can also participate
in the gains from a risky project if they opt for convertible bonds which give them the option of
converting into equity at a later date. The company may have valuable projects but the share
price may not reflect that in the financial markets. Managers can use dividends to send signals to
the market in an attempt to close any valuation gap. With dividends, again managers have more
information than investors; they can use the dividend to signal to investors how healthy the
prospects for the company are by either raising the dividend by more than normal or by cutting it.
Q5. Discuss the agency problems associated with too little debt in a company’s balance
sheet.
Ans. Too little debt in a balance sheet means the company has too much equity. Equity is more
forgiving than debt (debt is hard, equity is soft). Managers in the company with little debt will be
more able to miss targets and invest in poor projects without punishment. If the company had
higher levels of debt, they would have to generate certain levels of cash flow to service the debt
before anything could be paid to shareholders. If the company had more debt there would be a
value benefit from the tax shield that the shareholders could enjoy. The company with very low or
no debt will have a higher credit rating, but they will have a higher cost of capital than they would
otherwise have if they increased the amount of debt in the capital structure.
Q1. What are the advantages and disadvantages of hedging? Explain who would be
happier that the company was hedging - shareholders or bondholders. Describe how
Rosethorns might hedge the risk of their operations and what they would use.
Ans. The advantages of hedging are that there is certainty over future cash flows. It could be said
that by not hedging, the company is actually speculating because the final exchange rate or
interest rate is uncertain. With hedging, the company has the ability to remove the uncertainty.
Hedging can be relatively inexpensive. Bondholders will be more pleased that the company is
hedging, because it makes financial distress less likely. Shareholders would like the company to
hedge when it prevents losses, but they prefer the company not to hedge when prices are moving
in the company’s favour. There is also the problem of hedging when the underlying price has been
favourable to the company and rivals haven’t hedged, e.g., cocoa buyer, and cocoa prices are
falling. The hedger is locked in at the higher price, whereas those that didn’t hedge can take
advantage of the lower prices, which would allow them to reduce prices on the high street and
put pressure on the company that had hedged.
The company can use futures or forwards, which are low cost or options which are an expensive
form of protection. These can be used to protect against rises or falls in prices of anything from
interest rates to exchange rates and a large number of commodities.
Q2.Discuss the factors that affect the business risk of a company. Use the example of a
construction company and a food retail company to illustrate your answer.

Ans. The underlying business risk of a company is the ‘line of business’ or operating risk that lies
in a company. The level of business risk will reflect how variable the company’s operating profits
are. For a construction company it would be the business cycle it is part of. The down cycle in
construction can be particularly severe. It would be the level of fixed costs (degree of operating
leverage) in the business; it would be the volatility of the sector, it would be the strength of the
brand and the strength of the competition. It would be the ability of the company to control its input
costs or its ability to pass on higher input costs to its customers. It would be the ability of the
company to raise prices. It would lie in the levels of working capital needed to maintain the
business. It would be the rate of growth of the business and the ability to maintain that. It would
be the number of products that the company sells and what part of the market is it exposed to –
is it in residential construction or in commercial real estate (or both)?
The same type of analysis would apply in most parts to the food retail company. The food retail
company is less exposed to the business cycle as the population has to eat. This means the food
retailer could support much higher levels of debt. How much debt might depend on its position
within the sector. If there is a dominant player that can launch price wars, then this could put
pressure on an over-geared food retailer. It would also depend on how much of the sales of the
company were non-food. If these were high and there was a recession, these non-urgent
purchases could be dropped, putting pressure on the cash flows of the company. The food retailer
may also have strong asset backing; unless the property portfolio has been sold in a sale and
lease-back deal, then the company would be more exposed.
Q3. Identify and discuss the factors that a company should take into consideration before
it takes on financial risk.
Ans. Financial risk is the added risk that a company takes on top of the business risk outlined in
Part (1). The financial risk comes from the debt in the company balance sheet. The interest
payments that the company makes are made before the company can pay shareholders any
return. That makes the company more risky as far as the shareholders are concerned. The debt
can be a good thing because it comes with a tax benefit. The interest payments are tax deductible.
So the effect of borrowing will be to reduce the amount of tax paid: this is a valuable benefit.
But for the company to benefit it must be profitable to make use of these tax benefits, and they
must not just replace other tax benefits (e.g., depreciation tax shield). The company has to be
profitable enough to use up all tax benefits.
Because the company is now more risky, they should be sure that the company is able to pay the
debt interest in all scenarios, because if the company can’t pay the debt there is the danger that
the bondholders would take control of the company, potentially wiping out shareholders.
If the company is in a sector with very volatile returns, or is exposed to intense competition, or
faces constant price deflation it should adopt a more conservative capital structure. If the costs of
financial distress are potentially high for the company, e.g., loss of reputation, customers worried
about the future of the company, unique assets, again all these would point to lower debt in the
capital structure.
A key feature would be the strength of cash flow generation from operations. For example,
supermarkets generate huge cash flows which would support large amounts of debt. Many
software companies don’t generate large cash flows; the cash flows to a contract may be
staggered over a number of years, so this would work against them having large amounts of debt.

Q4. Companies in the real financial markets don’t have 100% debt in their capital structure.
Discuss the factors that work against companies having 100% debt in their balance sheet
as suggested in Modigliani and Miller with taxes (MM with taxes).
Ans. Modigliani and Miller’s original capital structure theorem excluded taxes. It said it does not
matter how the company is financed, the value will be the same.
This was then modified to reflect the real world friction of taxation. The original formulation
highlighted the benefit of the tax shield, which was valued as Tc*D. The more debt that the
company took on, the more valuable the tax shield. The value of the company was V = VU +
PVITS, the value of the ungeared company plus the present value of the tax shield. From this the
maximum value would be obtained when the company had 100% debt. This would maximise the
value of the tax shield.
However in practice we do not see companies with 100% debt.
Miller suggested that you need to take into account ALL the taxes that are paid by both the
company, shareholders and bondholders. Bondholders pay tax on the interest from bonds. The
personal income tax system is also a progressive tax system. Miller argued that as companies
issued more debt they would have to pay higher and higher rates as the investors were paying
higher taxes on their interest.
Other factors may claim tax credits, such as depreciation; this may work to give the company zero
income, so extra debt would not attract any tax benefit. The company needs to be profitable
enough to absorb all the tax benefits.
If an economy has an imputation system for dividends, this gives dividends some tax benefit, so
would also work against 100% debt. A position of 100% debt really leaves no room for error or
the company would end up in the hands of the bondholders. So as the debt ratio rises, the
bondholders would demand a higher return to compensate for the risk.
Past Paper Dec-2012
Q1. Traditionally the company has paid out a healthy regular dividend, but some on the
board are arguing for the dividend payment to be cut back in favour of share buybacks,
while actually increasing the amount of cash returned to shareholders on an annual basis.
Comment on the appropriateness of this policy and the possible motives behind it.
Ans. When a company pays a dividend, the share price is reduced by the amount of the dividend.
Executive option holders do not get the dividend, only shareholders receive it. So from a
manager’s perspective, they don’t get the dividend and the share price goes down. With the share
repurchase, the share price doesn’t go down, but shareholders have cash returned to them. With
the share repurchase, the number of shares outstanding goes down, so the earnings per share
will tend to rise. So from a manager’s perspective, the share repurchase looks a lot more
attractive; the share price does not fall as it does after a dividend payment. The share repurchase
might even push the share price higher, which would benefit the share options. The other benefit
is that it would boost earnings per share and that would raise the manager’s remuneration.
A benefit for ordinary shareholders from the share repurchase is that they would be able to defer
tax, as they are taxed immediately on the dividend. The share repurchase does not have the
same power as the dividend. A dividend is a commitment to pay out an amount of cash annually.

It is hard to change and it has strong signalling power. The share repurchase on the other hand
is more flexible; it can be turned on and off when the company feels like it (after they have won
approval from the shareholders in the first place to buy back shares).
Q2. This company rewards its managers for achieving earnings per share growth and
profitability targets. What are the advantages and disadvantages of eps growth versus
Economic Value Added as a reward measure for top managers at this company and any
company?
Ans. The company is actually producing profits. However, the company is not actually covering
the economic cost of its funds, based on the return on its assets. The company should look to
create wealth for the shareholders and produce a positive EVA. The company has a debt rate of
11% on the new borrowing and the cost of equity is likely to be higher still. The WACC of the
company is likely to be over 10% (once after tax cost of debt is factored in). The net income
(earnings after tax) is £14.385m for the equity funded option. With £180m in assets, the earnings
return does not cover the cost of capital. If the company could get its cost of capital down, these
investments would look a lot more attractive.
Too many companies are basing reward on eps growth or profitability. This is based on accounting
numbers only. EVA uses the accounting numbers (a disadvantage) but relates these to an
economic cost of funds. This is the total assets multiplied by the WACC. The company should
deliver income greater than this number. A company can be reporting profits but it is still
destroying shareholder wealth. EVA attempts to measure the wealth that managers are adding to
shareholders. EVA is a better measure than eps growth.
Q3. A German company is considering an inward investment in Russia, involving the
construction of a manufacturing plant, with the manufactured units being sold into the
Russian market. Describe the methods of evaluating that investment, and explain which
method is preferred and why.
Ans. There are two ways of evaluating the investment. The first method would discount future
Russian ruble cash flow estimates at a Russian risk adjusted discount rate and translate these
ruble values into euro values using the prevailing spot exchange rate.
The second method would predict future exchange rates between the euro and the ruble, apply
those to the ruble future cash flow estimates, convert into euros and discount future euro cash
flows to the present using the German company’s discount rate.
The best alternative is the first method. This has the virtue of freeing financial managers from
making estimates of long term future exchange rates, which is very difficult to do at the best of
times (however, long term forward rates are available through bilateral contracts with banks).
Q4. The German company will want to minimise its risk and is considering how to protect
its Russian investment.
(a) What advice would you give to the German company regarding hedging this
investment? Justify your answer.
(b) Advise the company on the appropriateness of the different hedging products
available. Explain why you would use certain products and not others.

Ans. (a) The German company is building a manufacturing plant in Russia, and as such will
be subject to a number of risks associated with doing business in Russia. The company will
face amongst others foreign exchange risk. When hedging forex risk the company should look
at the nature of the assets it is hedging. Real assets in the foreign country, such as the plant,
machinery and real estate need not be hedged since they will rise in value along with local
assets. Financial assets, such as the cash flow from the operations, if it is being repatriated
back to Germany, do need to be hedged. There is a risk that cash flows that are due out of
Russia may be worth less than expected if the exchange rate weakens against the euro. If the
company had borrowed to make this investment, there is a danger that the translated cash
flows may not be sufficient to service the debt, if the Russian Ruble were to weaken.
So the financial assets need to be hedged, to protect their value.
(b). The company can use Forward Rate Agreements (FRA), Futures contracts, swaps and
Options. The first three are similar, but options are quite different.
FRAs involve the company setting the price now for delivery at some point in the future of an
amount of currency. There is no cash flow to set the contract up, only a cash flow at expiry
when the contract will be closed out at the agreed rate. If the currency moves up or down, the
company is protected as they have fixed the exchange rate for that date in the future. Any
potential gains are sacrificed, but the company is covered against losses.
Futures are similar in that they fix a rate that you are willing to exchange at in the future. With
futures, however, there may be intervening cash flows, as the contracts are exchange traded
(FRAs are over-the-counter instruments) and a margin may have to be paid in to cover losses.
Currency swaps are like long term forward contracts. These allow the company to effectively
lock in long term exchange rates over the life of the project.
Each of these products are contractual obligations, the contracts must be fulfilled.
Options are different; they involve the payment of a premium up front (which is like an
insurance payment). They will protect the holder against an adverse movement. If there is an
adverse movement in the option, it does not need to be fulfilled and the holder can walk away
from the contract. The purchaser of the option contract will only lose as much as they pay for
it at inception. This is not the case with futures and FRAs.
Options are much more expensive than the first set of products, so it is likely that the company
would favour futures, forwards or swaps. If the exchange rate was particularly volatile, there
may be times when it would have been very advantageous not to have hedged, but if the
exchange rates are volatile, then the currency options would be very expensive to buy.
Q1. Explain the attractions of APV to companies compared to WACC/NPV. Give
examples of where companies might make use of the APV technique.
Ans. APV has the advantage of highlighting the present value of the financing effects of the
project. The WACC/NPV calculation just uses the WACC to discount the cash flows,
producing a single figure for the NPV. The APV will discount the all-equity cash flows by an
all-equity rate, then it will present value any tax shields or depreciation tax shield, or

subsidized borrowing rate, or government grant, using a discount rate that reflects the risk of
those cash flows.
So the APV is very good at isolating the benefit of these financing effects. Managers can see
how valuable the project is before any financing decisions are made. It may be that it is the
financing effects that produce a positive NPV (the APV figure will be the same as the figure
produced by the WACC/NPV).
Q2. Explain what the opportunity cost concept is in capital budgeting and give two
examples of opportunity costs.
Ans. An opportunity cost is a cost imposed on a project when it uses a company asset that
may have an alternative use. The opportunity cost is the value of the best alternative use. For
example, a company may own equipment that will be used by the project, if that equipment
had previously been rented out, the lost cash flows (after tax) will be the opportunity cost. Or
if the company owed property that could be sold or rented rather than being used by the
project, that is an opportunity cost. However, in this situation you must also take into account
the value that the property might have at the end of the project. So the true opportunity cost
is the present value difference between selling now and selling say in 5 years time.
Q3. Discuss how a large company would make use of an interest rate swap, and explain
how the swap works.
Ans. The interest rate swap is an agreement between two parties to exchange interest
payments in the same currency on an agreed amount of principal for a set period of time. One
party is exchanging a stream of cash flow with a counterparty that provides the other cash
flow.
One party may want to swap fixed interest payments (which it may be able to borrow at an
attractive rate) for floating rate payments. This situation may better suit the cash flows of its
business. The other party may have an advantage in borrowing in the floating rate market.
A bank is likely to act as the middleman in this arrangement for a fee. This arrangement has
an advantage over conventional derivative products in the length of time that it can run for.
Forwards and futures are for the relatively short term, whereas swaps will run for years.
There is counterparty risk in that you need to be sure that the other party will keep up the
payments on the interest rate obligation that you have swapped with them.
Using the swap can give companies a better match between their revenues and liabilities.
Q4. Explain your understanding of the concept of equity being regarded as a call option
in a geared company. Try and explain what the option variables are in the company and
how they affect the value.
Ans. If you have equity in a geared company, it is like a call option. The nominal value of the
debt is the exercise price (X), the value of the underlying assets of the company is the S0
value, the time until the expiry of the debt, the maturity is the time (t) of the option, the
variability of the cash flows of the company is the volatility (v) of the asset, and the interest
rate on the debt (the coupon) is the (r) in the model.

If the value of the underlying assets is greater than the value of the debt at maturity, then the
shareholders will buy the company back off the bondholders. If it is less than the value of the
debt, the shareholders will let the option lapse. This is their right under limited liability. For the
shareholders to buy the company back, S0/X must be greater than 1.0. The longer the maturity
of the debt, the more valuable the company will be as there is more time for something
beneficial to happen. The more volatile the cash flows, the more valuable the company. The
higher the interest rate, the higher the value of the equity within the company as the present
value of the outstanding debt will be reduced by the higher interest rate.
Past Paper Dec-2011
Q1. A company is about to enter into a sale and leaseback of its retail premises. What
are the factors it should consider and what are the disadvantages of this type of
exercise?
Ans. The sale and leaseback will release cash, usually the market value for the property. This
has the advantage of raising finance for the company selling the asset. This cash can then be
used to finance new projects, reduce debt, etc. The purchaser of the property will then lease
the property back to the previous owner. The previous owner will then start making lease
(rental) payments to the new owner. From outside the company, things will look the same –
the company is operating from the same premises, but it no longer owns that asset. With
something like property, what this means is that the previous owner gives up the salvage
value. With property that will be the eventual sale value which may be a sum, which actually
grows in value each year. The downside of sale and leaseback then is giving up that future
value and committing to renting. Sometimes sale and leaseback is used by companies in a
weak financial position to try and improve their cash situation.
Q2.Discuss the advantages that leasing offers a company.

Ans. The advantages of a lease are that the company has effectively an option on future
advances in technology. If a machine is bought, you have it for its economic life. With the
lease, if there are significant advances in the technology, having short leases allows you to
update the technology used by the company. The lessor is usually a large buyer of the
equipment and will be able to win significant discounts on the sale price. This would not be
available to the small company buyer, but the lessor can pass on some of these buying power
benefits in the form of lower lease payments. Leasing is similar to borrowing, so the lease
payment carries a tax shield benefit for the company. There may also be tax benefits from
leasing. A company may have temporarily low profits and as such may not be able to utilize
the tax shields that would go with borrowing or capital expenditure. The lessor will take
advantage of the tax shields on the equipment and can pass these on in the form of lower
lease payments to the lessee.
Q3. Discuss (i) the impact on the lease – buy decision of different depreciation
methods, and (ii) explain how the analysis of the lease – buy decision would change if
the company was in a non-taxpaying position. The accounting depreciation figure will
be the one used for tax purposes.

Ans. The accelerated depreciation will probably bring the depreciation tax shield benefits to
the company quicker so will be more valuable. The earlier the tax shield benefit the more
valuable it will be in present value terms.
If the company were in a non-taxpaying position, the tax shields would drop out of the analysis.
The cash flows would simply be the purchase price of the machine and any related costs
associated with the machine purchase, and the lease payment outflow. These would be
discounted at the company’s cost of debt – not the after tax cost of debt because it cannot
claim any tax benefit.
Q4. There are agency problems in the process of capital budgeting. Discuss what these
are and how they can be overcome.
Ans. The agency problems here may result in the wrong projects being selected. Managers
at different levels in the organisation may have pet projects that they would like to see
undertaken. It may result in them having command over a larger part of the business. If the
cash flows were too optimistic it would give the project a healthier NPV and make it more
attractive. Takeovers are just like large capital budgeting projects. They have a very poor
record of wealth creation for bidding shareholders.
The managers may also fail to abandon poor projects, instead pouring shareholders cash into
a losing situation. NPV analysis would give an indication whether these projects are worth
more alive or dead to the company. Proper scrutiny of the estimated cash flows of projects
may lead to better project selection and wealth creation for shareholders.
Q5. Explain what is meant by the term ‘duration’ with regard to interest rates and how
the measure would be used.
Ans. Duration is a measure of the riskiness of the bond’s cash flows. It measures the interest
rate sensitivity of the bond. Duration will give an indication of the change in value of a bond
for a 1% change in interest rates.
The measure duration is the number of periods into the future where a bond’s value is
generated. The greater the duration the further into the future the bond’s average value is
generated and the more sensitive it will be to changes in interest rates.
Zero coupon bonds (one cash flow at maturity) will have a duration that is equal to their
maturity. A coupon bond’s duration is the weighted average time to maturity, where the weight
for each period is the present value of the cash flow for that period.
Duration is a good measure for the sensitivity of a bond to interest rate changes. Investors
can use the measure to position themselves at different times in the interest rate cycle. If rates
are high and expected to fall, they would buy long dated high duration bonds. These are the
bonds whose price would rise most when interest rates start to fall.
Q1. For capital budgeting purposes (in general), how are the following treated in cash
flow analysis?
• Replacement decisions for machines with different lives

• Investment inter-relatedness
• Company overheads
• Creditors
Ans. Replacement decisions for machines with different lives: use an equivalent annual cost
calculation to compare the cost of machines on a comparable basis. Investment
interrelatedness: If investments are independent, they can be considered on their own. If there
is interrelatedness, then they cannot be considered on their own. A list of all possible
combinations is made (in the text it is rock concert arena/funeral parlour/record shop
example). The combinations must be mutually exclusive. The NPV of each combination is
calculated and the one with the highest NPV is chosen. Company overheads: Only overheads
that are specific to a project can be considered. General company overheads should be
ignored for project cash flow analysis. This is an accounting term and is applied on the basis
of arbitrary rules that may have little to do with the actual cash flows. Creditors: This will be
captured in changes to working capital. An increase in creditors will mean that working capital
is increasing over the period. Creditors on their own will not appear as a cash flow, only as
part of the working capital adjustment.
Q2. The APV method is often used as an alternative to NPV. Explain what you
understand about APV. What are its advantages and disadvantages?
Ans. Adjusted Present Value is a technique that uses discounting just like NPV, but delivers
the same result by a different route. The APV takes the all equity cash flows and discounts
these by the all equity discount rate (not the WACC). This is a rate that is as if the firm were
entirely financed with equity. The debt factor is stripped out. Financing effects are valued
separately. If the company has debt, the interest tax shields will be valued at the pre-tax debt
rate. What this does is to separate the investment and financing effects. The project can be
seen to be good or bad without the influence of debt. The debt financing effect (or any other
financing effect such as subsidised debt) can be viewed in isolation. This will determine if the
project is only good because of the benefits of debt. APV is also useful when debt is
decreasing. WACC/NPV assumes a constant level of debt, whereas APV can see different
levels of debt being used during the life of the project. This is a key strength of APV: it gives
more information to the user. It is useful in evaluating debt financed takeovers.
Q3. What are the main factors that should be considered by company directors when
deciding on company dividend policy?
Ans. Main factors:
• Sustainability of dividend over the longer term
• The need for cash by the company
• The signal that will be sent to shareholders about the company’s prospects
• Levels of taxation
• Flotation costs, if it is expensive to raise new equity, the company may retain cash

Q4. Discuss further the three views on dividend policy. What are the merits or
drawbacks of each policy?
Ans. Stable policy: this gives rise to a predictable dividend from year to year. This will attract
institutional investors who like the constancy of the dividend policy. The dividend can be used
as a signal by the company; good prospects raise the dividend. A problems with it is that it
becomes difficult for the company to cut its dividend if needed. This is because they fear the
effect on the share price and the reaction of the institutional investors.
Irrelevance: Dividend irrelevance only really holds in a perfect market, but with market
frictions dividends are relevant.
Residual policy: Dividend will be unpredictable, fluctuating from year to year. This will make
it very difficult for investors to know what level of dividend they will be paid. The advantage to
the company is that they would be using internal funds to finance all positive NPV projects,
and only after that would they pay a dividend.
Q5. What can the company’s P/E ratio be used for? What are the problems with using
this ratio?
Ans. The P/E ratio can be used to compare companies within the same industry to try and
compare valuations and levels of riskiness and future growth rates. The problems with P/E is
that one of its components, the share price, is the result of a huge number of factors, only one
of which is the last period’s earnings. Also a company’s P/E ratio is a very complex number
in terms of the information that can influence it. It is affected by the pattern of dividends that a
company pays, its payout ratio, the riskiness of the company as evidenced by the equity
discount rate, and the stream of earnings that the company is expected to generate in the
future.
Past Paper Dec-2008

1. Identify and discuss four key factors in the company borrowing decision.
2. Explain why in a company that is in financial distress managers may favour a riskier
project to a
safe project?
3. Discuss the likely capital structure implications of the following two examples:
a. A company earns very little profits and pays no tax.
b. Managers at a company believe the shares to be undervalued.
Identify and discuss four key factors in the company borrowing decision.
Among the most important factors are: 1) the ability of the company to generate cash flow to
service the interest and principal requirements at the appropriate times; 2) the ability to fully
utilise the tax shields that come with borrowing; 3) the asset backing the company has that
can be offered as collateral in case of default; and 4) the ability to access the financial markets.

Other considerations in the capital structure decision would be the likely costs of financial
distress, building in flexibility into the capital structure so that the company can still take
advantage of good projects (this follows from point 4 above). The theme underlying points 1
and 3 is the danger of financial distress. The company must have enough cash to service the
debt and they must have assets that they can sell if they get into financial distress. Point 2
means the company must be profitable. If it is not profitable, then it cannot take advantage of
the tax shield. Point 4 means that the company should have easy access to further capital if
needs be. There is nothing about the company that would prevent it from accessing the
financial markets.
Explain why in a company that is in financial distress managers may favour a riskier project
to a safe project?
If a company is in financial distress, there will already have been a large fall in the value of
the equity. If the company were to be liquidated at that point most, if not all, of the value would
probably go to the bondholders. The shareholders would be left with nothing. If the choice of
projects arose at this point, the safe project may just earn enough money to further improve
the bondholder’s position, leaving the shareholders no better off. The safe project may even
have a higher expected NPV than the risky project, but there is a small chance that the risky
project would pay off, in which case the shareholders would gain. Managers’ aim is to
maximize shareholders wealth, and since it is effectively the shareholders who pay the
managers the managers would favour the riskier project in the hope of a payoff for the
shareholders. This is an agency problem in the capital structure.
Discuss the likely capital structure implications of the following two examples:
(a) A company earns very little profits and pays no tax.
(b) Managers at a company believe the shares to be undervalued.
(a) If the company is not making any profits and is paying no tax, then there are no benefits
to borrowing to the company. The reason for borrowing is to take advantage of the tax shield.
If you can’t take advantage of it, there is no point in borrowing. The company should be equity
financed.
(b) If the managers at a firm believe that the shares are undervalued, then they are more likely
to fund themselves with debt. Any new projects would be financed with debt as the markets
do not recognize the actual worth of the company. The company may also borrow money to
buy back shares, thus increasing the gearing element.
Q1. 1. In capital budgeting, describe how the following items are treated in the project
appraisal:
− Product cannibalisation
− Depreciation
− Interest charges

2. How does capital rationing affect a company and how capital budgeting techniques
can help
resolve the problem?
3. What is the problem with IRR and mutually exclusive projects, and how can it be
overcome?
Ans. In capital budgeting, describe how the following items are treated in the project appraisal:
− Product cannibalisation
− Depreciation
− Interest charges
Product cannibalisation refers to the situation where a company launches a new product or
service and that affects the existing range of products and services. This can steal sales away
from the existing offering thus lowering cash flows. This has to be taken into account when
estimating the cash flows when evaluating the project. A cash flow loss would have to be built
in to reflect the loss in sales. This would be the case unless the company was involved in a
very competitive sector where they would have lost sales whether they introduced a new
product or not, as in, for example, the mobile phone market and the personal music player
market. If you don’t launch a new product, you will lose sales to the new product from the
other company.
Depreciation is not a cash flow, but it does have an impact. The company will benefit through
the depreciation tax shield, so they will pay lower taxes as a result. When the company buys
new machinery, the cash is gone at the start. Depreciation recognises this over a longer time
frame. Depreciation can be straight line or accelerated. If accelerated, the company benefits
because they will receive a greater time value benefit.
Interest charges are ignored in the cash flows; they are built into the discount rate that is
applied to the project. The after tax cost of debt is used. The interest tax shields are excluded
from the analysis.
2. How does capital rationing affect a company and how capital budgeting techniques can
help resolve the problem?
Capital rationing can be internal or external. External capital rationing should not exist. This is
the capital markets effectively not supplying the company with capital. If the company has
identified good projects (positive NPV) to invest in, the market will provide the company with
capital, but the company might not like the price the markets are charging for the capital. The
market might decide the company is too high a risk and charge a substantial premium for debt
or equity capital. The capital markets may disagree with the figures that the company is
producing, thus hiking the price of capital. Internal capital rationing is when the company itself
imposes restrictions on the number of projects it will fund. The company will have an annual
budget for projects and the different parts of the company will have to bid for the money.
The way the company will decide on which projects to invest in will be on the basis of NPV.
The company will use NPV in conjunction with the profitability index (PI) to see which projects
will generate the largest total NPV for the company. The PI will indicate to the company which

projects produce the greatest return per £ invested, but this will not reflect the scale of the
project. The NPV
itself will tell which projects together will deliver the largest NPV.
3. What is the problem with IRR and mutually exclusive projects, and how can it be overcome?
With mutually exclusive projects, we have to choose among competing projects. Ideally, we
want to choose the projects with the highest NPVs. With IRR, projects will have their quoted
IRRs, but it would be wrong to rank the projects on the basis of their IRRs. This is because
the IRR does not reflect the scale of the project. Also the IRR may be higher for one project
than another, but when analysed using the company cost of capital the results are the other
way round. This is due to th pattern of the cash flows over the life of the project. One way of
overcoming this problem is to do an incremental cash flow analysis of the two projects. This
is the defender and challenger analysis. The project with the highest nominal cash flow is the
defender and the other is the challenger. Subtract the challenger cash flows from the defender
and find the IRR of the remaining cash flows. If the IRR is greater than the hurdle rate, keep
the defender. If not, keep the challenger. This will choose the project that will deliver the
greatest NPV.
Past Paper Dec-2007
1. A company wishes to use more short term debt rather than longer term debt because
it is usually cheaper. They also want to maintain a low level of current assets; current
liabilities will make up a high proportion of total liabilities. Comment on the return and
risk to the company from these actions. And discuss more generally return and risk
with regard to managing a company’s working capital.
2. For each of the main elements of working capital, explain how companies might
exercise better control over these items.
1.
The company in question is being very aggressive in its working capital management. Short-
term debt usually has a lower cost than long term debt, but it is riskier. Short-term debt has to
be continually rolled over (renewed). Interest rates might rise, cash flows at the company may
suffer a shortfall – a large customer may take longer than expected to pay their bills. If the
company is short of cash and can not pay the bankers, it is likely to suffer penalties. Because
the company is running such a high level of current liabilities and a low level of current assets,
there may be times where it does not have enough inventory to meet demand, which will result
in customers going elsewhere. On the surface it looks like the policy could boost profits – they
are financing themselves at a cheaper rate, but this has to be weighed against the increased
risks the company is taking.
Looking at managing working capital, in general, we would ask are short term assets higher
or lower risk than long term assets? Short-term assets are inventory, cash, marketable
securities, etc. Long-term assets are plant, equipment, machinery, etc. Just examining the
above list you can see that the short term assets are very close to cash, whereas with the
long-term assets they are more difficult to turn into cash. The short-term assets are more
liquid; they can be turned into cash quickly without much loss in value. Short-term assets can
have a wide range of uses by many companies, whereas the longer term assets are much

more specific to particular companies, e.g. certain machines may have very limited uses, so
there would not be many potential purchasers of the machines. The short-term assets have
low risk so they will have low return also. The machinery cited above may have a unique use
which may be able to generate very high rates of return because there are very few
alternatives. So long term assets will generate greater rates of return. With regard to financing,
short term financing is riskier because it has to be renewed or rolled over more often. There
is a risk that the lender may not renew the borrowing. Longer term finance is taken out for
years so there is not the same pressure on renewal.
The differences between short and long-term finance depend on the reversibility differences
between the types of finance. The company agrees to service the debt for the term. Short
term finance, if not needed, can be cancelled relatively quickly; this is not the case for long-
term debt. Short-term finance has lower costs but this means higher returns. But if a firm has
too high a level of long-term finance, it will be paying interest for the use of finance when the
funds aren’t needed. A firm may adopt what is known as a maturity matching approach. This
is where the firm would only be servicing long term debt when the business was in a seasonal
trough; as the business picked up in its peak period, it would finance itself more with short
term debt and the short term debt would be paid off with the cash generated from that peak
in short term activity. The risk and return characteristic of a firm’s financing is that short-term
financings exhibit relatively higher expected risk and return, and long-term financings, lower
risk and return. This is the opposite of the risk return characteristic of its assets.
2.
The elements of working capital are, on the current assets side, cash, marketable securities,
accounts receivable, and inventory. On the current liabilities side, there is accounts payable,
and the short-term loans and other financings. Managers adopt policies for managing short-
term assets. With cash and marketable securities, there may be a policy whereby if cash falls
to a certain level, marketable securities will be sold to replenish the cash levels. A simple
economic order quantity model can be used to determine the optimal reorder points, or the
more sophisticated Miller-Orr cash replenishment model can be used. These models aim to
minimise transaction costs and lost interest. Inventory management is similar to management
of cash and marketable securities in that economic order quantity models will be used to
minimise order costs and maintain inventory levels. Management of accounts receivable is
more difficult. The company needs to get the balance correct between offering too much
credit, which would boost sales, but may result in high bad debts, and too little credit, which
will hold back sales in comparison, but minimise bad debts. The company can buy credit
reference reports which will indicate the payment history of prospective customers. There is
a cost to this, but it means the company might be able to avoid non-paying customers. Another
way to manage the timing of the cash flow from customers is to offer discounts for early
payment. Here the company has to be wary of just granting discounts to customers who would
have paid on time anyway, and the company still has a bad debt problem. With regard to
accounts payable on the current liabilities side, the question here will be: should the company
pay early to take advantage of a discount offered by a customer? The company can work out
the cost of finance if they do not take up the discount and pay early, comparing the company’s
short term borrowing cost against the rate implied by not taking up the discount. Usually the
discount would be attractive to the company so should be taken up. Working capital is best
seen as being ‘managed’ in an ongoing process, rather than being decided upon in discrete

terms. The rule of thumb is to match maturities of assets and financings. This helps highlight
the important differences between short- and long-term commitments which the company
makes in its asset portfolios and financings and, in particular, the risk and return differences
among them.
Working capital management involves two levels of activity:
− The ‘hands-on’ application of management techniques to specific asset and financing
decisions (e.g. how much cash, or inventory to have on hand at any one time, what credit
conditions to set for customers to buy on credit, or whether or not a discount should be taken
by paying a supplier before a bill is finally due).
− The optimal setting of policies for such decisions so that each of these small decisions is
almost automatically determined by the company’s well considered policy. Working capital
management cannot be considered independent of a company’s cash budget. Without a plan
as to the generation and usage of cash over time, the best management techniques have no
data upon which to operate. An up-to-date or real time cash budget is a necessity for effective
working capital management.
______________Good-luck___________

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