Answer any 4 Questions from each Part

Part 1

Question 1:

(a) A company's shares over the last four years were priced at 250p, 240p, 260p, and 258p (in chronological order). The shares paid a dividend of 5p in each year. Calculate the annual returns on the company and both the arithmetic and geometric average annual returns over the four year period.

(b) An account in Building Society Alpha pays 7.4% interest, compounded quarterly, while another Building Society Beta pays 7.5% with annual compounding. You have £1,000 to invest. What is the value of your investment in these Societies after three years? Which Society do you prefer? What additional amount would you have to invest in this Society at the start of the fourth year to achieve a future value of £2,000 at the end of the fourth year?

(c) BMA Plc's next dividend is expected to be 24p per share and is expected to grow at 8 percent thereafter. If its current price is 200p, what rate of return does the market require from BMA?

Question 2:

(a) Rank the following alternatives in terms of present value assuming a discount rate of 6 percent.

(i) A growing perpetuity paying £15,000 each year, with the first payment due immediately. The growth rate of the perpetuity is 2 percent.

(ii) A four-year annuity paying £100,000 each year, with the first payment in one year's time.

(iii) A growing perpetuity paying £12,500 each year, with the first payment in one year's time. The growth rate of the perpetuity is 3 percent.

(iv) A payment of £375,000 in two years' time.

(b) As a winner of a business game competition you are to receive cash payments of £5,000 at the end of each of the next three years. Assuming a nominal discount rate of 7 percent, what is the present value of these cash flows? If the rate of inflation is 2 percent in years one and two and 3 percent in year 3, what are the values of these cash flows in real terms and what are the real discount rates for years one, two, and three? Show that discounting real cash flows using real discount rates gives the same present value as discounting nominal cash flows at a nominal discount rate.

(c) A bond has 5 years remaining to maturity and pays annual coupons at a rate of 7%. It has an annual yield-to-maturity of 8% and a face value of £100.

(i) What is the current price of the bond?

(ii) If market interest rates applicable to this type of bond are currently at 8% per year, would the price that you computed in (i) be a fair price to pay for the bond? Explain why.

Question 3:

(a) ‘An IPO is a costly undertaking and therefore firms should avoid conducting an IPO.' Do you agree with this statement? Why or why not?

(b) How do firms go private? How are these public-to-private (PTP) transactions funded?

Question 4:

(a) You are a portfolio analyst and have been given the task to evaluate three stocks (Stocks A, B and C). Suppose the Treasury bill rate is 4 percent and the market portfolio return is forecast to be 12 percent.

Required:

(i) You know that Stock A has a beta of 1.5. What is its required rate of return?

(ii) You know that the required rate of return on Stock B is 18 percent. What is its beta?

(iii) Stock C has a beta of 1.4, and you forecast its return as 14 percent. Will you buy Stock C? Why or why not?

(iv) Suppose a stock lies below the Security Market Line (SML). Explain what this means, and what is likely to happen to the price and return of such a stock.

(b) In the context of risk and return in corporate finance, explain what we mean by the terms "beta" and "market risk premium".

(c) You have a portfolio consisting solely of Stock A and Stock B. The portfolio has an expected return of 10.2%. Stock A has an expected return of 12%, while stock B is expected to return 7%. What are the portfolio weights of the two stocks? Explain the theory behind your answer.

Question 5:

(a) Prett Ltd is a small company with annual net operating income (NOI) of £40,000 and a market value of all its assets of £200,000. At present, the company is entirely equity financed. Its new chief financial officer (CFO) has proposed issuing corporate debt to raise £120,000; the proceeds of the debt issue are to be used to retire an equal amount of equity. The CFO has hired you to advise her on the impact of her plans on the rate of return on equity of the company.

Required:

(i) Calculate the rate of return on equity given the present capital structure (all equity). Briefly explain your method and result.

(ii) Calculate the rate of return on equity following the proposed change in capital structure assuming that the company operates in a perfect capital market without any taxation, and that the expected return on Prett's corporate debt is 13 percent. Briefly explain your method and result, and comment on your assumptions.

(b) Compare and contrast the assumptions and predictions of the trade-off model and of the pecking order model of capital structure.

Question 6:

Explain and critically discuss the following TWO statements relating to the supposed purposes of company payouts to shareholders in the form of dividends and share repurchases:

(a) Payouts allow insiders to signal favourable private information to uninformed outside investors.

(b) Payouts reduce the agency conflict between managers and shareholders.

Part -2:

Question 1:

(a) A bond with two years to maturity and an annual coupon of 9% is available. The bond has a face value of £100 and the next coupon is payable in one year.

Required:

(i) If the market requires a yield to maturity of 9% for a bond of this risk class, what will be the market price for this bond?
(ii) If the market price is £98, what yield to maturity does it offer?
(iii) If the required yield to maturity on this type of bond changes to 7%, what will the market price of this bond change to?

(b) As a winner of a lottery you can choose one of the following prizes:

(i) £1,000,000 now
(ii) £1,700,000 at the end of five years
(iii) £135,000 a year for ever, starting in one year
(iv) £200,000 for each of the next 10 years, starting in one year

If the time value of money is 9%, which is the most valuable prize? Will you choose to go for the most valuable prize? Why/Why not?

(c) The annual rate of inflation is a constant 5%. The annual real rate of interest is a constant 3%. Nominal cash flows at the end of the next three years are £600, £1,050 and £1,800 respectively. Calculate the corresponding real cash flows and the present value of their sum using the real rate of interest.

Question 2:

(a) You have the following information on MAFGEE Plc

Estimate the fair value of MAFGEE's stock and hence recommend whether the market is currently over- or under-pricing it.

(b) A Building Society is advertising a flat rate of interest of 14 percent on a deposit account. The Society operates a system of weekly compounding. What is the effective annual interest rate on this account? Assume 52 weeks in the year.

(c) Briefly discuss how financial analysts value companies in practice.

Question 3:

(a) Discuss the main theories that explain the underpricing of IPOs. 

(b) Discuss the theories of long-run underperformance of IPOs

Question 4:

Teneris Plc is interested in acquiring Premier Group. Premier is privately owned and operates a chain of city centre hotels in the UK. Premier's founder and owner Linda Wallis is considering retirement and is interested in selling. Teneris has asked your advice in setting a price for Premier's equity.

You have gathered the following information on four similar companies that operate in the same industry and are of similar size to Premier. These companies have the following characteristics:

You also note that the expected return on market (Rm) = 13% and the risk-free rate (Rf) = 2%

Premier's debt equity ratio is 25/75. It‘s latest earning figures (before deduction of interest) are £3.9 million per annum. These earnings can be assumed to remain constant for the indefinite future.

You may ignore taxation and inflation.

Required:

(a) (i) For each of the similar companies 1 to 4, find the cost of equity in terms of the return required by investors in the stock of the company.

(ii) For each of the similar companies 1 to 4, calculate the weighted average cost of capital (WACC).

(b) (i) Find the asset value of Premier using the no-growth discounted cash flow approach. Premier's WACC can be approximated by the average of the WACC of firms 1 to 4.

(ii) Calculate the value of Premier's debt and equity.

(c) If Premier's cost of debt is 12% and its WACC is approximately the same as the average WACC of comparable firms 1 to 4, what is its cost of equity and its equity beta?

Question 5:

(a) You believe that the possible future returns on three securities are as follows:

Required:

(i) What are the expected returns for each of the three securities?

(ii) Calculate the variances and standard deviations of returns of the three securities.

(iii) If the current prices of securities B and C are 200p and 125p, and you buy 1,025 shares of security B and 800 shares in security C, what are the portfolio weights? What are the expected return and standard deviation on this portfolio?

(iv) What can you say about the standard deviation of the portfolio calculated in (iii)?

(b) What do you understand by systematic and unsystematic risk? Explain giving examples.

Question 6:

(a) Do companies follow a residual or a managed payout policy? Discuss in the light of empirical evidence on dividends and share repurchases.

(b) Discuss whether and how taxes might affect the payout policies of companies.