HERIOT-WATT UNIVERSITY

FINANCE – JUNE 2021

Section I

Case Studies

Question 1

(a) In the question you are given the equity and debt betas of the company and the debt
weight. You have all the information needed to calculate the company asset beta
(ungeared beta). This is the sum of the weighted betas. Once we have the company
ungeared beta, we need to adjust it for the differences in risk between the company
and the project. The company beta will be multiplied by 1+project fixed
costs/1+company fixed costs. Then the resulting beta will be then multiplied by the
project revenue volatility/ company revenue volatility. The resulting beta will be the
ungeared beta for the project.

We then need to calculate the equity beta for the project. We have the project beta
and the project debt beta and the weights of debt and equity. So we rearrange the
weighted beta formula to solve for the missing equity beta.

Once we have the equity beta, we can work out the costs of equity and debt and put
these together for the WACC. The calculations are shown below:

PARENT beta weight weighted beta

Equity 1.15 0.75 0.8625
Debt 0.15 0.25 0.0375
ungeared beta = 0.9

Project fixed costs = 0.41 1.41

Company fixed costs= 0.55 1.55
adjustment= 0.9097

adjusted beta = 0.8187

Project revenue volatility = 0.95

Company revenue volatility = 1.25
adjustment = 0.7600

adjusted beta = 0.6222

PROJECT weight weighted beta

Project equity beta 0.8370 0.6 0.502
Project debt beta 0.30 0.4 0.12
ungeared beta = 0.622

Risk-free rate = 4.50%

Stock market risk premium 6.00%

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 Cost of equity for project = 9.522%
Debt rate for project = 6.300%
Tax rate = 30%

Weighted equity cost 5.713%

After tax weighted debt cost 1.764%
WACC = 7.477%

Full marks for correct answer. Fewer marks for errors in the calculation.

(b) The cash flows are laid out below, the WACC of 7.477% is applied to the FCF* and an
NPV of £4.17m is produced. The cash flows are as follows:

Installation
Equipment 28.5 (cap) 1.5
Installation
Depreciation -5 (exp) 1
Tax 30%

Year: 0 1 2 3 4 5 6
Initial investment -31.00 6.00
Working capital -2.50 -0.80 -0.30 -0.30 0.70 0.40 2.80
Revenues 8.00 10.00 11.50 13.23 13.23 13.23
Revenue enhancement 0.75 0.75 0.75 0.75 0.75 0.75
Operating costs -3.50 -3.75 -4.00 -4.25 -4.50 -4.75
Tax 0.30 -0.08 -0.60 -0.98 -1.42 -1.34 -3.07
Free cash flows -33.20 4.38 6.10 6.98 9.01 8.53 14.96
Discount factor 1 0.930 0.866 0.805 0.749 0.697 0.649 NPV
Discounted cash flows -33.20 4.07 5.28 5.62 6.75 5.95 9.70 4.17

Tax calc 0 1 2 3 4 5 6
Taxable cash flows -1.00 5.25 7.00 8.25 9.73 9.48 15.23
Depreciation -5.00 -5.00 -5.00 -5.00 -5.00 -5.00
Pre-tax -1.00 0.25 2.00 3.25 4.73 4.48 10.23
Tax at 30% 0.30 -0.08 -0.60 -0.98 -1.42 -1.34 -3.07

Working capital calculation:

0 1 2 3 4 5 6
Working capital -2.5 -3.3 -3.6 -3.9 -3.2 -2.8 0
Change -2.5 -0.8 -0.3 -0.3 0.7 0.4 2.8

Full marks for correct answer. Fewer marks for mistakes in the cash flows.

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(c) Accounts receivable and accounts payable are figures that go to make up the
company accounts. They represent money that is owed to and by the company,
respectively. They do not represent actual cash flow. They will be cash flows in the
future. The figures for accounts receivable and accounts payable do not go in the
cash flow.

The two items are part of the working capital of the company. The relevant figure for
the cash flow is the change in working capital from period to period. This represents
either more or less cash resources of the company being tied up in working capital.
An increase in accounts receivable from one period to the next, for example, would
represent a cash outflow (it may be reduced if there is also an increase in accounts
payable). At the end of the project these balances are assumed to be paid down and
reduce to zero.

Full marks for correct description and analysis. Answer needs to highlight
cash flow effect accurately. Fewer marks for brief or weak answer.

(d) If the company was not paying taxes, then it could not claim the tax shield benefit
attached to debt or the depreciation tax shield. The effect of this would be to lower
the available cash flows to the project because the company would not be able to
shield cash flows from tax. A similar tax paying company would have higher project
cash flows because of the tax shield effect.

The impact would be to make the company more likely to fund itself with equity, and
perhaps lease machinery as the lessor may be able to pass on some tax benefits in
kind to the non-tax paying company.

Full marks for similar coverage. Key point is not being able to claim the tax
benefits, and pushing the company away from debt funding. Progressively
fewer marks for weaker coverage.

(e) Interest rates do not appear in the cash flows, the interest deductibility for tax
purposes is captured in the cost of capital. Debt costs are expressed in an after tax
basis, so the cost of debt is reduced by multiplying the debt rate by (1 – tax rate). If
interest rates appeared in the cash flows, you would be double counting.

Opportunity costs are the best alternative use of a company asset, rather than being
used for the project. For example, the company may own an asset that could be sold
or rented rather than used for the project. The opportunity cost would be the foregone
income from rental or the loss of revenue from the sale (but if looking at the sale of
the asset, you have to take into account the value that you could sell the asset for at
the end of the project if you undertook the project. So the opportunity cost here is the
present value difference between selling it today and selling at the end of the
project).

Full marks for similar coverage. Fewer marks for weaker coverage.

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Question 2

(a) The spot rates are found by dividing the price of the zero coupon into the par value
(100) and taking to the root of the number of years.

ZC bond par = 100

Year price spot yield full return
1 95.45 0.04767 1.04767
2 90.62 0.05048 1.10351
3 85.74 0.05262 1.16632
4 81.16 0.05357 1.23213

Full marks for correct answers. Give credit if simple error has resulted in
wrong answer. Fewer marks if they don’t know how to obtain spot rates.

(b) The forward price is gained, for example using the one year forward starting in year
one by using the following formula:

(1 + 0 s 2 ) 2
(1 + 1f2) =
(1 + 0 s1 )

in this case = 1.10351

1.04767

= 1.05330

subtract 1.0 to obtain the forward rate = 5.33%

The rest of the forward rates can be obtained in a similar manner.

The full set of forward rates is set out below:

forward rates
1f2 1.05330 5.330%
2f3 1.05692 5.692%
3f4 1.05643 5.643%

2f4 1.11656 5.67%

The 2f4 rate will produce a two-year return; this must be square rooted to give an
annualised forward rate.

Full marks for all correct. Four marks for the correct one-year rates, plus two
marks for the correct two-year rate. Give credit if they have the correct method
but wrong answers carried from part (a). Fewer marks for more errors.

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(c) The bond price is obtained by discounting the bond cash flows by the set of spot
rates.

Coupon: 6.5
Term: 4
Year: 1 2 3 4
Value: 6.5 6.5 6.5 106.5
Discount factor 1.0477 1.1035 1.1663 1.2321
Disc c/f = 6.20 5.89 5.57 86.44 £104.10
Bond Price

Full marks for correct bond price. Give credit if they have correct method but
wrong answer from part (a). Very few marks if they don’t seem to know how to
price the bond.

(d) An interest rate swap is a derivative instrument that allows companies to hedge their
interest rate risk. For example, the company that has the bond in issue in part (c) has
a fixed rate bond. This means they will pay the same debt service every year, it has
been fixed. It may be more appropriate for the company to have debt service that
fluctuates with short term interest rates; its revenues may move more in line with
short term interest rates. The fixed rates may impose a burden on the company at
the wrong time.

The company would then arrange to swap the fixed rate obligation for a floating rate
obligation. A bank would facilitate this transaction for the company. No principal
exchanges hands, only the interest payments are swapped and the company will
repay the full principal at the bond’s redemption. The swap is effectively a series of
forward transactions; only the cost of the swap is less than a series of forwards (and
is more convenient).

The company uses the swap to give more certainty to its cash flows. It may be that
the fixed commitment would have left it short of cash flow, whereas the floating
obligation is more manageable.

Full marks for similar coverage. Answers should explain what a swap is and
who would use it and how it works. Fewer marks for weaker coverage.

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(e) Duration measures the riskiness of a bond or the sensitivity of the bond to changes in
interest rates. The bond price is very sensitive to changes in interest rates, so the
duration measure is useful to bond investment managers. The higher the value, the
more price sensitive the bond is to interest rate changes.

The calculation is as follows:

Coupon = £7

Cash Discount PV of Cash PV of

Years Spot rate
flow Factor Flow c/f × time

1 7 0.957 6.699 6.699 4.50%

2 7 0.907 6.349 12.698 5.00%
3 7 0.852 5.961 17.884 5.50%
4 107 0.792 84.754 339.016 6.00%
103.763 376.297
Duration = 3.627

Full marks for similar description and correct calculation. Fewer marks if they
have only answered one part of the question. Give credit if they have mainly
correct workings.

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 Section II

Short Questions

1. 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, there is more time for something beneficial happening. The more volatile the
cash flows the more valuable the company. The higher the interest rate the more
valuable the equity part of the company will be, lower interest rates will lower the
equity value (follows S0 – PVX).

Full marks for similar coverage. Answer must go through the option variables
and relate it to equity in a geared company. Fewer marks for weak analysis.

2. Real options are strategic options that give management the chance to change their
decision once new information becomes available. Conventional capital budgeting,
i.e. discount cash flow analysis is static, not dynamic. Real options allow for
decisions to be changed in the light of changing market dynamics.

An option to expand could be used by an oil company, for example an early project
would be the exploratory phase. If information emerges that there is an oil discovery,
the oil company has the option to expand or abandon. If there is enough oil they will
expand and if the oil price is high enough to make the field economical to develop. As
they do further exploration, they may find that the field is bigger than originally
thought and they can expand further. Oil exploration can be viewed as a series of
real options.

Full marks for similar coverage, fewer marks for vague coverage and no
examples.

3. Economic value added (EVA) is a performance indicator that measures how much
value managers have created over and above an economic charge on their assets.
Earnings per share is just an accounting number, where the net income is divided by
the number of shares in issue.

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.

Full marks for similar coverage. The answer needs to cover the merits of each
and the weaknesses. Fewer marks for general answers and weak coverage.

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4. 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 chemicals company it would be the business
cycle it is part of. 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 (one or many?).

The same type of analysis would apply in most parts to the software company. They
may have less operating leverage, as they will not have the fixed asset infrastructure
that the chemicals company has. They would focus on the development of products
and the growth of the company.

Full marks for similar coverage addressing the business risks of both sectors
in some detail. Fewer marks for general coverage.

5. 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. Problems with it is 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.

Full marks for detailed coverage of each dividend policy. Fewer marks for weak
analysis.

© Heriot-Watt University, June 2021