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FINANCE FOR MANAGERS

UNIVERSITY OF EXETER

BUSINESS SCHOOL

May 2019

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FINANCE FOR MANAGERS

Module Convenor: Aurel Kucani

Duration: TWO HOURS

Answer TWO questions from SECTION A

AND

Answer TWO questions from SECTION B

100 marks in total available on this paper (which will be scaled to represent 80% of overall module marks)

Section A: Each question carries 25 marks. You have a free choice of two from three questions.

Section B: Each question carries 25 marks. You have a free choice of two from three questions.

Commence each question on a new sheet of paper.

You should explain any symbols you use and show clear workings.

Materials to be supplied: Formula sheet and present value tables are attached.

Materials to be supplied on request: None

Approved calculators permitted.

This is a closed note examination.

 

 

2 BEA3008 Turn over

SECTION A

(Answer TWO questions only)

 

QUESTION A1

a) You have just turned 30 years old, and now you must decide how much money to put into your retirement plan. You decide that you will plan to work until you turn 60 and live to 80. The plan works as follows: every pound in the plan earns 6% per year. You cannot make withdrawals until you retire on your 60th birthday. After that point, you can make withdrawals as you see fit. You estimate that to live comfortably in retirement, you will need £50,000 per year starting at the end of the first year of retirement and ending on your 80th birthday. Assume that your starting salary is £70,000 per year and it will grow 5% per year until you retire. What percentage of your income do you need to contribute to the plan every year to fund the retirement income?

(11 marks)

b) Suppose that there are only two possible future states of the world. In one state a company’s share price will rise by 40% from its current level, and in the second state it will drop by 25%. The current share price is £100, the exercise price of a European call option written on this share is £110, and the risk-free rate of interest for the period until expiration of the option is 4%. Calculate the hedge ratio and the current value of the call option using a one- period binomial option pricing model.

(6 marks)

c) Discuss the advantages and disadvantages of the following investment appraisal technique: Net present value.

(8 marks)

[25 marks in total]

 

 

 

 

 

 

 

 

 

 

3 BEA3008 Turn over

QUESTION A2

a) The finance director of Tarata is concerned about the lax management of the company’s trade receivables. The trade terms of Tarata require settlement within 30 days, but its customers take an average of 50 days to pay their bills. In addition, out of total credit sales of £10 million per year, the company suffers bad debts of £150,000 per year. Tarata finances working capital needs with an overdraft at a rate of 9% per year. The finance director is reviewing two options:

Option 1: offering a discount of 1% for payment within 30 days. It is expected that 40% of customers will take the discount, while the average time taken to pay by the remaining customers will remain unchanged. As a result of the policy change, bad debts would fall by £50,000 per year and administration costs by £15,000 per year.

Option 2: the debt administration and credit control of Tarata would be taken over by a factoring company. The annual fee charged by the factor would be 1.8% of sales. Tarata would gain administration cost savings of £140,000 per year and a 90% reduction in bad debts. The factor would reduce the average trade receivables days of Tarata to 30 days and would advance 80% of invoices at an interest rate of 13%.

Which option should the finance director choose?

(14 marks)

b) Sinkus Ltd produces chairs and tables from material provided by local suppliers. The company has an estimated requirement in 2019 for 24,000 units of stock from its suppliers to meet customer demand. Sinkus’s estimated annual carrying cost per unit of stock is £6, and its estimated cost of placing and receiving each stock order is £40.

i. On the assumption that Sinkus Ltd will not consider stockouts, perform calculations to ascertain Sinkus’s optimal 2019 stock ordering policy; and the total annual cost of this policy.

ii. Sinkus Ltd is considering allowing stockouts to occur and estimates that the cost of

such would be £10 per unit of average stockout. Assuming that Sinkus is willing to face stockouts, re-perform calculations to ascertain Sinkus’s optimal 2019 stock ordering policy; and the total annual cost of this policy.

(11 marks)

[25 marks in total]

 

 

 

 

 

4 BEA3008 Turn over

QUESTION A3

a) A two-asset economy comprises assets with the parameters in the following table and a

covariance of return between the two assets of -0.2.

Asset 1 Asset 2

Expected return 0.04 0.2

Variance of returns 0.2 0.5

The market portfolio has an expected return of 0.12 and standard deviation of returns of 0.237. The risk-free rate of return is 4%.

Required:

i. Explain and discuss beta under the Capital Asset Pricing Model (CAPM). (7 marks)

ii. Calculate the CAPM beta of asset 1.

(5 marks)

iii. Confirm that CAPM holds for asset 1. (2 marks)

 

b) Aler plc has a current share price of 110 pence cum dividend. The dividend last year was 10 pence per share. The company has, and intends to maintain, a policy of increasing its annual dividend by 5% each year. It has a debt to equity ratio of 1:2 and the pre-tax market cost of debt is 10% per annum. The company operates in a perfect capital market with the exception that corporation tax is charged at 30%. It has substantial taxable profits and its debt and equity prices are in equilibrium.

Required:

i. Calculate the company’s existing cost of equity capital (rounded to four decimal places).

(3 marks)

ii. Deduce what the cost of equity would be if the company were all equity financed (rounded to four decimal places).

(5 marks)

iii. Decide whether or not the company should undertake a project that would provide an internal rate of return of 10.2 % with the existing capital structure.

(3 marks)

[25 marks in total]

 

 

 

5 BEA3008 Turn over

SECTION B

(Answer TWO questions only)

 

QUESTION B1

d) Define market efficiency and critically discuss its implications to investors and firms’ managers.

(15 marks)

e) Define risk management and discuss some of the techniques available to reduce risk exposure.

(10 marks)

[25 marks in total]

QUESTION B2

a) In the context of portfolio theory, assuming no risk-free asset, define the feasible (opportunity) set and explain how it differs from the Mean-Variance Efficient (MVE) frontier. How would a risk-averse investor choose their optimal portfolio? (Use appropriate, well- labelled diagrams to illustrate your answer).

(15 marks)

b) In the context of dividend policy irrelevance discuss the following theories: clientele effect, signalling theory, and bird-in-hand argument.

(10 marks)

[25 marks in total]

QUESTION B3

a) From the perspective of the firm which requires financing, critically discuss the characteristics of the following sources of long-term finance: ordinary shares and preference shares.

(12 marks)

b) Explain what is meant by the Pecking-order theory and how it relates to observed capital structure of companies.

(13 marks)

[25 marks in total]

 

END OF PAPER

FORMULAE SHEET AND TABLES FOLLOW

 

 

6 BEA3008 Turn over

FORMULAE SHEET

IRR ≈ R1 + NPV 1 x (R2 – R1)

(NPV1 – NPV2)

Inventory

Cost of sales x 365 = Inventory period

Accounts Receivable

Credit Sales x 365 = Accounts Receivable Period

Accounts Payable

Credit Purchases x 365 = Accounts Payable period

Cash Cycle = Inventor Period + Accounts Receivable Period – Accounts Payable Period

 

 

 

 

 

 

E r = ω E[r ] + ω E[r ]

Var r = σ = ω σ + 2ω ω σ , + ω σ

 

E(r ) = r + (E(r ) − r )

σ σ

))(()( fmf rrEjrrjE  

 

C = P C + 3P (1 − P)C + 3P(1 − P) C + (1 − P) C

R

 

WACC = k S + (1 − t )k B

S + B

 

WACC = ρ (1 − t B

B + S )

 

 

TABLES FOLLOW

   

N

n ininii RERPRVar

1 ,

22 )()( 

)()( RVarRStd iii   ))())(((),( ,,

1

RERRERPRRCov jnjini N

n nji  

RPRE ni N

n ni ,

1 )( 

 

 

Table 1: Present value of 1 unit received n periods in the future with an assumed appropriate constant discount rate of r per period

r n

1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026 21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135 0.112 0.093 0.077 0.064 0.053 0.044 0.037 0.031 0.026 0.022 22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123 0.101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018 23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112 0.091 0.074 0.060 0.049 0.040 0.033 0.027 0.022 0.018 0.015 24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102 0.082 0.066 0.053 0.043 0.035 0.028 0.023 0.019 0.015 0.013 25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010 26 0.772 0.598 0.464 0.361 0.281 0.220 0.172 0.135 0.106 0.084 0.066 0.053 0.042 0.033 0.026 0.021 0.017 0.014 0.011 0.009 27 0.764 0.586 0.450 0.347 0.268 0.207 0.161 0.125 0.098 0.076 0.060 0.047 0.037 0.029 0.023 0.018 0.014 0.011 0.009 0.007 28 0.757 0.574 0.437 0.333 0.255 0.196 0.150 0.116 0.090 0.069 0.054 0.042 0.033 0.026 0.020 0.016 0.012 0.010 0.008 0.006 29 0.749 0.563 0.424 0.321 0.243 0.185 0.141 0.107 0.082 0.063 0.048 0.037 0.029 0.022 0.017 0.014 0.011 0.008 0.006 0.005 30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004

 

7 BEA3008 Turn Over

 

 

8

Table 2: Present value of an annuity of 1 unit received at the end of each of the next n periods with an assumed appropriate constant discount rate of r per period

r n

1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870 21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891 22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909 23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883 8.266 7.718 7.230 6.792 6.399 6.044 5.723 5.432 5.167 4.925 24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985 8.348 7.784 7.283 6.835 6.434 6.073 5.746 5.451 5.182 4.937 25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948 26 22.795 20.121 17.877 15.983 14.375 13.003 11.826 10.810 9.929 9.161 8.488 7.896 7.372 6.906 6.491 6.118 5.783 5.480 5.206 4.956 27 23.560 20.707 18.327 16.330 14.643 13.211 11.987 10.935 10.027 9.237 8.548 7.943 7.409 6.935 6.514 6.136 5.798 5.492 5.215 4.964 28 24.316 21.281 18.764 16.663 14.898 13.406 12.137 11.051 10.116 9.307 8.602 7.984 7.441 6.961 6.534 6.152 5.810 5.502 5.223 4.970 29 25.066 21.844 19.188 16.984 15.141 13.591 12.278 11.158 10.198 9.370 8.650 8.022 7.470 6.983 6.551 6.166 5.820 5.510 5.229 4.975 30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979

End of Paper

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