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EXAMINATION PAPER: ACADEMIC SESSION 2016/2017

Campus Greenwich Maritime and International Partners

Faculty Business

Department Accounting & Finance

Course Code FINA 1027

Course Title Finance - EXAM

Level 6

Duration THREE HOURS

Date May 2017

Course co-ordinator: Patricia Ntozi-Obwale

INSTRUCTIONS TO CANDIDATES

Section A is compulsory.

You must also choose 3 questions from Section B.

This is a CLOSED book examination.

Non-programmable calculators are permitted.

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Section A
This is a compulsory question.
Background
Bate is a UK Multinational Food and Drink Company specialising in the production of
breakfast cereals, convenience snacks and dairy foods. The company has seen a significant fall
in its market share due to local and EU competitors. The board of Bate plc has therefore decided
to expand its operations into a promising country, Zamunda, where strong economic growth
for the next 10 years has been predicted. The board has further decided to set up a wholly-
owned subsidiary as a method of entering this market.

Proposed Investment
The estimated financial data about the proposed investment is provided as follows:

1. Net operating cash inflow in Zamunda is estimated in the local currency below:

Year 1 2 3 4
Z$’000 320 430 550 600

2. The cost of a new machine is $800,000 while the scrap value of the machine has been
estimated as 2.5% of the original cost of the machine.
3. The factory was purchased last year at a cost of $340,000.
4. Initial working capital of $104,000 will be required at the beginning of the project and
additional working capital will be required for the next 3 years. For each year this will
be 2% the initial working capital. At the end of the project, the accumulated working
capital will be released.
5. The current spot rate is Z$ 1.23: £1 and the risk free interest rates per year in the two
countries are expected to be 1% in the UK and 2% in Zamunda.
6. Bate plc will pay Zamunda tax on its profits at a rate of 22%, while UK tax on profits
will be payable at 28%. All profits will be remitted at the end of each year and there is
a double taxation treaty between the two countries. In both countries, tax will be paid
in the year in which profits arise.

Project Evaluation
Bate plc intends to use WACC to evaluate the project and the following extract from the
financial statement has been provided:
£’000
Ordinary share capital (£1 par value) 7,500

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Reserves 2,000
9% Preference share (£1 par value) 2,500
6% irredeemable bond 12,000
Total 24,000

Other information
 Current market prices are £7.10 for ordinary shares, £1.45 for preference shares and
£92 for 6% irredeemable bonds.
 Dividends are estimated to grow at an annual rate of 5% for the foreseeable future.
 Bate Plc has just only paid a dividend of 60p per share.

Required:
a) Estimate the Z$ to £ exchange rate for the four years on the assumption that interest
rate parity between the two countries is expected to hold during the life of the project.
(4 marks)

b) Compute the company’s Weighted Average Cost of Capital (WACC)

(13 marks)

c) What is the Net Present Value (NPV) of the four year project in sterling (£) and advise
Bate plc on whether this is an acceptable project. (18 marks)

d) Explain in general, five motives for which companies such as Bate plc would pursue a
strategy of Foreign Direct Investment (FDI) (5 marks)

(Total 40 marks)

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Section B
You are to choose 3 questions from this section

Question Two
Depo Corporation is considering two alternative investments in bonds. Detailed information of
these two bonds is listed in the table below. The 2-year and 10-year bonds have different times
to maturity but carry the same default risk.

A 2-year bond A 10 year bond

Par value (£100) 100 100
Coupon rate 7% 7%
Current yield to maturity ? 6.8%

Required:

(a) “There is an inverse relationship between interest rates and bond prices”. Is the
above statement correct? Explain.
(4 marks)

(b) If the market price of the 2-year bond of Depo Corporation is £95, would the
yield to maturity be above or below the coupon rate of 7%? Explain.
(3 marks)

(c) Consider the 10-year bond and calculate the bond price at the time of issue.
(5 marks)

(d) If in one year’s time, the yield to maturity for the 10-year bond has reduced by
0.2%, what will the total return of this bond be after one year’s time?
(8 marks)
(Total 20 marks)

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Question Three

Pintos plc is a listed company. It has issued share capital of 4 million ordinary shares with
nominal value of £1.00 per share. The company needs to raise some capital to finance a new
product. The board of the company has decided it needs to raise £1.5 million, after issue costs
are deducted. The company has been advised that the additional finance can be raised by means
of a 1 for 5 rights issue. The issue price will be at 20% discount to its current ordinary share
price of £2.50. The issuing costs are expected to be £75,000.

Required:

(a) Ms Jones is a small investor who owns 1000 shares of Pintos plc. Using the
information provided, show the amount of shares Ms Jones can purchase and at
what price if she decides to subscribe to the rights issue.
(4 marks)

(b) Calculate and explain the following:

i. The theoretical ex-rights price per share
(4 marks)

ii. The net cash raised

(3 marks)

iii. The value of the rights

(3 marks)

(c) Critically discuss the factors to be considered by Pintos plc in using a rights
issue as a way of raising new equity finance. Be sure your answer should include
the following:
i. A discussion of the difference between actual and theoretical ex-
rights price
(3 marks)

ii. Other ways in which Pintos plc could raise the new equity
finance
(3 marks)
(Total 20 marks)

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Question Four

Newtech plc, a company that belongs to the technology intensive sector, has just paid a £1
dividend per share since its foundation 10 years ago. Analysts are divided about the company’s
dividend policy in the future.

Part of the analysts (Team A) expect Newtech’s dividend to grow at 25% per year for the next
three years and then 5% per year thereafter. The current required rate of return on the stock
according to Team A is 18%.

Team B analysts, on the other hand, expect Newtech’s dividend to grow by 50% in the next
two years and then 10% per year thereafter. Furthermore, Team B are more optimistic than
Team A as reflected in their estimate of the required return for Newtech to be 15% (Team B).

Required:

a) What is the current value of the stock according to the predictions of Team A?
(6 marks)

b) What is the current value of the stock according to the predictions of Team B?
(6 marks)

c) Discuss if it is a worrying sign for the prospects of Newtech that it paid a dividend for the
first time in its 10 year history. (8 marks)

(Total 20 Marks)

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Question Five

You have the following information on the performance of the stock of RIPRO plc and the
performance of the market in the last four days:
Return on RIPRO Market Return
Time plc (%) (%)
T1 1.6 1.8
T2 2.3 3.4
T3 4.5 8.9
T4 2.3 1.2

Dividends of RIPRO plc in the last five years are provided below:
Year 2012 2013 2014 2015 2016

Dividend per
share 80p 82p nil 81p 82p

The rate of return of the risk-free rate is 1% and the correlation coefficient between the stock
of RIPRO plc and the market is 0.94.

You are required to answer to the following:

a) Calculate the required rate of return of RIPRO plc using the CAPM (12 marks)

b) Estimate the market price of one share of RIPRO plc (4 marks)

c) An essential part of the CAPM formula is the rate of return of the risk-free asset. Discuss
why government bonds of highly indebted governments, such as the recent downgrading of
Greece and Portugal, are least preferred as proxies for the risk-free rate. (4 marks)

Total 20 Marks

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Question 6
WCM Ltd has been particularly concerned about its liquidity position in recent months. The
following are extracts from the most recent annual accounts at the end of 2016 and 2015.
2016 2015
£’000 £’000
Sales 600 380
Current assets
393 160

Opening Stock
80 70
(Inventory)

Purchases 430 170

Closing Stock
180 80
(Inventory)

Debtors 200 60
Cash and cash
13 20
equivalents

Current liabilities 355 125

Trade creditors 150 70

Bank overdraft 120 30

Tax 45 15
Accrued expenses 40 10

Net working capital

38 35
Long-term debt 102 100

Required:
a) Compute the cash conversion period for WCM Ltd for both 2015 and 2016.
(10 marks)
b) Discuss whether the management of WCM Ltd should worry about its Working Capital
Management, and give your advice to the management on how to improve this position.
Support your analysis using cash conversion period, current ratio, bank
overdraft/current liability, sales/net working capital ratio and other information you
think is important. (10 marks)

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FINA 1027 Formulae Sheet

DIVIDEND MODELS
Constant dividend
Ke = Div
MV (Po)
Dividend Growth
Ke = D1 +g
MV (Po)
MV (Po) = D1/(ke – g)

Cost of Debt for an irredeemable bond

Kd = I(1-Tax)
MV
Weighted Average Cost of Capital
WACC = E x Ke + D x Kd (1 –T) + .............
E + D + …………
Standard Deviation
σx = √Σ((xi – x )2pi)
Mean return & standard deviation for historic data n

 (R - R)
i
2

S tan dard deviation ,  

n i 1
 Ri n
Mean return, R  i 1
n
Standard Deviation: two asset portfolio

Covariance
n

 (R - Ri)((R - Rj)
i , j 1
i j

Co var iancei , j 
n

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Cov i, j
Correlation Coefficient =
 i j

Capital Asset Pricing Model (CAPM)

rj = rf + ß(rm – rf)

Beta of a Security
βj = (σj σm ρjm)/σm2

Internal Rate of Return (IRR)

 NPV LR 
IRR = LR +  x (HR - LR)
 NPV LR - NPV HR 

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