HERIOT-WATT UNIVERSITY

FINANCE – DECEMBER 2020

Section I

Case Studies

Question 1

Fox-Johnston plc is a UK-based manufacturer whose main product is the ‘Govinator’, a

clever piece of equipment that saves time for its owner to do other things. It is an
automated lawn maintenance server. It will cut the grass perfectly and dispense feed to
the lawn at the same time and also has an aeration function. This takes a lot of effort out
of gardening.

The Govinator is made in the UK, but the specialised wheels, an essential component,
are made outside the UK in Europe. The Finance Director has noticed that the cost of
these wheels has been rising in price relentlessly over the last three or four years. He has
now reached the stage where he is thinking it might be better to make the wheels in the
UK and free the company of the costly European contract.

He has asked you to put together a costing with an estimated NPV if the company
switched to 100% UK manufacture. To do this, Fox-Johnston would have to buy a
special piece of precision engineering equipment, which will come from Germany and
will cost £700,000. There will be £100,000 of shipping and installation costs associated
with the purchase, £60,000 of which would be capitalised, and the rest can be expensed
straight away. The new equipment would be depreciated down to a salvage value of
£100,000 and it is expected that at the end of the five-year project the equipment could
be sold for that salvage value.

It is estimated that the costs of manufacturing the wheels would be £600,000 in the first
year and that this cost would rise in the future at a rate of 6% per annum. The cost of
continuing to buy the wheels from Europe is estimated to be £900,000 in the first year
and this cost would rise at a rate of 10% per annum into the future. There will be
increased working capital requirements with the project. Initially £90,000 of extra
working capital will be required and this would rise to £110,000 at the end of year 1 and
rise again to £130,000 at the end of year 2, and from there it will remain constant until its
return at the end of the project.

Extra debt has been taken on for this project, which will result in annual interest
payments of £35,000 through the five years. There will be a one-off cost of £250,000 in
year 1 of specialist training of staff and extra quality supervision. The wheel assembly will
take place in part of the facility that has been rented out to promising start-up businesses.
The rentals had been running at £150,000 per year and that revenue stream will stop if
Fox-Johnston decides on the all-UK solution.

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The new equipment will have to be serviced by a specialist team from the German
supplier as part of the ongoing warranty. This will take place at the end of the second and
fourth years and will cost £80,000 each time.

Fox-Johnston has an equity beta of 1.86, the risk-free rate of interest is 3.5% and the
market risk premium is 6%. The company has a bond outstanding with five years to
maturity, its price is £94.50; and it has a coupon of 8%, the yield to maturity for this
bond is 9.45%. This is a normal line of business project for Fox-Johnston and the
company is typically financed with 35% debt. The tax rate is 25%.

Required: Maximum Word Count 1000 words

(a) Calculate the cost of capital for the project.

(3 marks)

(b) This is a make-or-buy decision for Fox-Johnston. Lay out the cash flows and
calculate the NPV. What course of action would you recommend for the
company?
(10 marks)

(c) Using an inappropriate discount rate is a common cause of mistakes in capital

budgeting. If a company wanted to set up a new division in an area unrelated to its
normal line of business, outline the steps that the company should take to
establish a correct discount rate for the project.
(6 marks)

(d) You can find equity betas for companies on financial websites such as ft.com. In
October 2020, the drug company Astra Zeneca had an equity beta of 0.51 and the
oil company Bowleven had an equity beta of 1.90. How would you interpret and
explain these two figures? Also, explain how the equity beta differs from the asset
beta.
(6 marks)

(e) Discuss why capital rationing might occur and clearly explain how a company with
a limited budget would choose among a number of projects. Why might hard
capital rationing occur and what could a company do to minimise this?
(5 marks)

Total 30 marks

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Question 2 Maximum Word Count 1000 words

(a) Taxation has a major impact on many financial decisions.

(i) Discuss the ways in which tax impacts on the company’s payout decision.

(ii) In the UK during the Covid crisis, the Government banned companies that
had received financial help from the state from paying dividends. Do you
think the state has a role in deciding the level of dividends and can you
think of any similar situations where dividend restrictions would be
imposed on managers?
(9 marks)

(b) Apart from taxation, identify and discuss in detail four key factors that would have
an influence on the dividend decision by a company. How would each of these
factors influence the dividend decision? Use examples where you can.
(6 marks)

(c) Share repurchases have overtaken dividends by value as a form of shareholder

payout in the US. Discuss whether share repurchases are a good use of company
cash. What motivations do you think management has in returning more cash via
share repurchases?
(7 marks)

(d) Asymmetric information plays an important role in the financial markets and
affects the value of companies. What is the problem surrounding asymmetric
information and can you give a recent example where this agency issue caused
problems in the financial markets.
(8 marks)

Total 30 marks

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 Section II

Short Questions

Maximum Word Count 3500 words

1. The current share price of Verafon plc is 230 pence. Over the coming year, the
share price is expected to either rise or fall by 60%. The two outcomes have equal
probabilities. The risk-free interest rate is 4.5%.

(i) Using the binomial option pricing model, what is the value of a call option
on Verafon with an exercise price of 220 pence?

(ii) What is the exercise (i.e. intrinsic) value of the option?

(iii) What is the premium (i.e. time value) of the Verafon option?
(8 marks)

2. Amazon does not pay a dividend and has a poor record of profitability over the
past decade. Explain from a finance viewpoint how the company is worth over $1
trillion if it pays no dividends? Discuss whether you think that valuation is
justified. Illustrate your answer with fast growing technology companies in a
similar situation in the past.
(8 marks)

3. The following are the prices of a one-year, two-year, three-year, and four-year
government zero coupon bonds respectively; £86.96, £77.64, £71.89, £65.35.

(i) Calculate the set of spot interest rates that can be obtained from these
bonds.

(ii) Using the spot interest rates calculated above, calculate the two-year
forward starting in two years’ time and the one-year forward starting in
three years’ time.
(8 marks)

4. Debt has a tax advantage over equity in most markets, in that the interest payable
is deductible before taxes are calculated. Discuss what you think would happen if
this advantage to debt were removed and neither debt nor equity had any tax
deductibility. Should companies still have debt in their capital structure?
(8 marks)

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5. Calculate the value of the following two stocks: Acorn Tech and Lime Media.

Acorn has reported earnings per share of 80p and has a dividend payout of 40%
and the dividend has just been paid. Acorn’s weighted average cost of capital is
9% and they have 25% debt in their capital structure. The tax rate is 30%. Acorn’s
dividends are growing at 4% per year.

Lime has grown its dividend steadily over the years. In 2010 was 8p and in 2020 it
was 19p. The company faced a tax rate of 30% as well, the risk-free rate of interest
is 2% and the market risk premium is 6%. Lime has no debt and its beta is 1.8. Its
payout ratio is lower at 30%.

What are the share prices of Acorn and Lime?

(8 marks)

Total 40 marks

END OF PAPER