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This paper is not to be removed from the Examination Hall

UNIVERSITY OF LONDON AC3059 ZB

BSc degrees and Diplomas for Graduates in Economics, Management,

Finance and the Social Sciences, the Diplomas in Economics and Social
Sciences

Financial Management

Thursday, 17 May 2018: 10:00 to 13:00

Candidates should answer FIVE of the following EIGHT questions: FOUR from
Section A and ONE from Section B. All questions carry equal marks.

Workings should be submitted for all questions requiring calculations. Any

necessary assumptions introduced in answering a question are to be stated.

8-column accounting paper is provided at the end of this question paper. If used, it
must be detached and fastened securely inside the answer book.

A calculator may be used when answering questions on this paper and it must
comply in all respects with the specification given with your Admission Notice. The
make and type of machine must be clearly stated on the front cover of the answer
book.

PLEASE TURN OVER

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SECTION A

Answer FOUR questions from this section.

Question 1

Indigo plc has a market value of equity of £6m and a market value of debt of £2.5m.
It pays 6% for its debt financing and has a beta of equity equal to 2.17. Suppose
that the effective tax rate is 25%, the expected return on the market portfolio is 15%
and the risk-free interest rate is 5%. Indigo plc is now considering investing in one of
two new mutually exclusive projects P and Q. Both projects P and Q have a life of 4
years and are similar to the firm’s existing operations.

Projects Cash Outflow (£000) Cash Inflows (£000)

Year 0 Year 1 Year 2 Year 3 Year 4
P 200 10 40 140 70
Q 150 70 60 100 80

Required:

a) Calculate the cost of equity capital and the weighted average cost of capital
(WACC) after tax of Indigo plc.
(6 marks)

b) Evaluate the net present value (NPV) of projects P and Q. Which project
should Indigo plc accept, according to the NPV method?
(8 marks)

c) Suppose now instead that Indigo plc is all-equity financed, that is, it has no
debt in its capital structure. Assume the same beta of equity, risk-free interest
rate and market risk premium as above. Indigo plc is considering investing in
the mutually exclusive projects P and Q as above. Which project should be
accepted, according to the NPV method, in this case? Assume that the
projects are similar to the firm’s existing operations.
(6 marks)
(Total 20 marks)

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Question 2

You have estimated the following two-factor structure for three well diversified
portfolios (labelled A, B and C).

The expected returns on portfolios A, B and C have been estimated to be 10%, 15%
and 20% [the expected factor realizations, E(I1) and E(I2) are nil].

Required:

a) Solve for the APT pricing equation and interpret your result.
(12 marks)

b) Now there is a new asset D, which has exposures of 5 and 2 to factors 1 and 2
respectively. What is its no arbitrage expected return?
(8 marks)
(Total 20 marks)

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Question 3

The statements of financial position and income statements for the year ended 30
June 2017 of Cosmo Ltd and Bendix Ltd, two companies in the same type of
business, are given as follows:

Statements of financial position at 30 June 2017

Cosmo Ltd Bendix Ltd

£ £ £ £
Non-current
assets: cost 90,000 30,000
Accumulated
depreciation 30,000 10,000
60,000 20,000
Current assets
Inventories 85,500 30,000
Receivables 33,000 20,000

Cash 16,500 10,000

135,000 60,000
Total assets 195,000 80,000

Equity
Equity share
capital 142,500 45,000
Retained earnings 7,500 5,000
150,000 50,000
Current liabilities
Trade payables 45,000 30,000
45,000 30,000
Total equity and
liabilities 195,000 80,000

Question continues on next page

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 Income statements for the year ended 30 June 2017

Cosmo Ltd Bendix Ltd

£ £ £ £
Revenue 240,000 120,000
Opening inventory 58,500 20,000
Purchases 171,000 85,000
229,500 105,000
Closing inventory (85,500) (30,000)
Cost of sales (144,000) (75,000)
Gross profit 96,000 45,000
General expenses (84,000) (39,000)
Profit before tax 12,000 6,000
Taxation (3,000) (1,000)
Profit for the year 9,000 5,000
Dividends paid 6,000 1,500

You may assume that inventories have increased evenly throughout the year.

Required:

a) Calculate the following ratios for each company.

i. Return on capital employed
ii. Asset turnover
iii. Net profit margin
iv. Gross profit margin
v. Current ratio
vi. Acid test (ratio)
vii. Inventory turnover
viii. Receivables collection period
ix. Payables payment period.
(9 marks)

b) Discuss the main conclusions drawn from a comparison of ratios calculated for
each company.
(11 marks)
(Total 20 marks)

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Question 4

Suppose you are the owner of company Orion plc. The company has debt maturing
next year with face value £100m. The company will be generating next year when
the debt is due a cash flow equal to either £120m or £60m with equal probability.
There is no cash at hand and no subsequent expected cash-flow. Assume risk
neutrality and no discounting.

Required:

a) Based on the information, what are the market values of debt and equity?
(6 marks)

b) Now suppose you have an opportunity to invest another £20m that can yield
additional £25m with certainty on top of the currently projected outcomes.
What is the NPV of this additional investment? What is the market value of
debt and equity after the investment? lf you, as the owner, have to fund the
investment out of pocket, should you invest? Explain.
(6 marks)

c) lf instead you were to issue new debt that was more senior than the current
debt to finance the new investment, what would be its fair face value? What is
the market value of the original debt and equity? Should you issue this new
debt and invest?
(4 marks)

d) How would your answers to parts b) and c) change if the face value of debt
was equal to £60m?
(4 marks)
(Total 20 marks)

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Question 5

Scorpius plc is considering acquiring Draco plc. You have the following data:

Scorpius plc Draco plc

Expected EPS £5.00 £1.50
Expected DPS £3.50 £0.80
Number of Shares 1m 0.8m
Stock Price £90 £20

a) You estimate that investors currently expect a steady growth of 6% in Draco

plc’s dividends and earnings. Under new management, this growth rate would
increase to 8% per year, without any additional investment required. What is
the overall gain from this acquisition?
(9 marks)

b) What is the cost of this acquisition if Scorpius plc pays £25 in cash for each
share in Draco plc?
(2 marks)

c) What is the cost of this acquisition if Scorpius plc offers one share of Scorpius
for every three shares of Draco?
(6 marks)

d) How would the cost of the cash and the share offers alter if after the merger
the expected growth rate was not changed by the merger?
(3 marks)
(Total 20 marks)

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Question 6

Answer all parts of this question:

a) A portfolio manager has been able to beat the market over the last five years
(i.e. her portfolio has a mean return over the last five years that exceeds the
market’s mean return over the same period). Does this provide evidence
against the efficient market hypothesis? Discuss.
(5 marks)

b) Today, the 2-year spot interest rate in the UK is 0.1%. The 2-year spot interest
rate in the US is 1.16%. The spot FX market tells me that £1 is worth exactly
$1.25 today. lf the market two-year forward exchange rate of Sterling for US
Dollars is $1.29 per £1, find out whether an arbitrage is available and, if so,
show how to exploit it.
(5 marks)

c) Assume a one-period binomial setting for stock Nova. The stock currently sells
for £20. Over the next period its price will either rise to £26 or fall to £16. The
one period interest rate is 10%. A one-period call option with strike price £23
exists. It is currently selling in the market for £1.50.

i. Show that this call option is mispriced.

(6 marks)

ii. Devise and explain in detail an arbitrage strategy that generates risk-free
profit from the mispricing.
(4 marks)
(Total 20 marks)

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SECTION B

Answer ONE question from this section.

Question 7

Event studies are important for evaluating the semi-strong form of the efficient
market hypothesis, as well as studying the effects of key corporate announcements.
Explain what the semi-strong form of the efficient market hypothesis means. Next,
explain how you would design an event study to examine the price impact of
earnings announcements.
(Total 20 marks)

Question 8

Answer all parts of this question:

a) Provide empirical evidence on the impact of dividend announcements on stock

prices.
(8 marks)

b) Explain how this empirical research is affected by asymmetric information

regarding the quality of firms’ investment projects?
(12 marks)
(Total 20 marks)

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