Summer Assessment 2020

Assessment paper and instructions to candidates:

FM474L – Managerial Finance

Suitable for all candidates

Instructions to candidates

This paper contains ten questions. Answer all questions.

If at any point in this examination you feel that anything is unclear, please make any
additional assumptions that you feel are necessary and state them clearly.

Precision, clarity, and legibility will all be valued and rewarded in grading.

Specify the question numbers that you answered in the box provided on the
coversheet for submission.

Instructions on how to scan and upload your answers can be found on the course
Moodle page. It is your responsibility to ensure that your answers are legible,
including the scanned versions of your answers.

Time Allowed: You have a 24-hour window to complete and submit your assignment.
The exam was written with the intention that it should take 2 hours 30 minutes for
students to complete. We recommend that you spend 15 minutes reading the exam
paper before you begin writing your answers.

Permitted materials: This is an open-book, open-notes exam.

Calculators: Calculators are permitted in this assessment.

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Part 1 – Multiple choice questions
There are 6 multiple choice questions (5 marks each). Each question contains 4 statements, which can be
either true or false. Each question has at least one correct statement. Choose only the correct statements
for each question; no explanation is required. If you choose only a subset of the correct statements for a
question, you will earn partial credit proportionally (for example, if there are 3 correct statements, and you
choose only 2 of them, you will earn 2/3 of the 5 marks). If you choose an incorrect statement, you will earn
zero marks on that question, even if you also choose some correct statements.

1. (5 marks) Which of the following statements are correct?

a. Under perfect capital markets, a firm’s asset beta is not affected by the firm’s capital structure.
b. Under perfect capital markets, the expected rate of return required by shareholders increases
with leverage for a positive beta stock.
c. Firms with low taxable earnings tend to have lower debt-to-value ratios than firms with high
taxable earnings.
d. In the presence of corporate taxes and financial distress costs (and absent other market
imperfections), the value of a levered firm is higher than the value of an unlevered firm.

2. (5 marks) Which of the following statements are correct?

a. All else equal, an increase in accounts receivable and/or an increase in depreciation in a given
year decrease a firm’s unlevered cash flows in that year.
b. A company’s Return on Equity (ROE) is a poor measure of the company’s performance during
the year.
c. The Internal Rate of Return (IRR) of an investment opportunity that requires a deposit of £100
today and pays £250 two years from today is higher than 60%.

d. If a company’s accounts receivable are expected to remain outstanding for 180 days and the
company’s annual revenues are £100 million, the accounts receivable of the company are £25
million.

3. (5 marks) Which of the following statements are correct?

a. Consider a project that generates a negative cash flow in year 0 and a positive cash flow in
year 1. The NPV rule will always lead to the same decision for this project as the IRR rule.

b. Higher NPV projects have longer payback periods.

c. Two projects with identical expected cash flows but different risk profiles have the same IRR.

d. IRR is affected by the scale of the investment opportunity.

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 4. (5 marks) Which of the following statements are correct?
a. Stock A has an expected return of 10% and a standard deviation of 15%, and stock B has an
expected return of 13% and a standard deviation of 14%. No investor would ever buy stock A
because it has a lower expected return and a higher risk than stock B.

b. A firm is expected to pay a dividend of £3 per share in one year. This dividend is expected to grow
at a rate of 7% forever. If the current market price for a share is £67, the company’s cost of equity
is higher than 11%.

c. A 10-year bond has an annual coupon rate of 6% and face value of £100. The bond pays
semi-annual coupons. If the yield to maturity on the bond is 10% per year, the price of the
bond must be below par.

d. A higher yield to maturity implies that a bond’s expected return is higher.

5. (5 marks) Which of the following statements are correct?

a. A company anticipates a perpetual debt level of £12 million at an interest rate of 4%. If the
company’s tax rate is 35%, the present value of the interest tax shields is higher than 4 million.

b. An all-equity firm has a beta of 0.8. If the risk-free rate is 5% and the market risk premium is 4%,
the WACC of the company is lower than 8%.

c. According to the CAPM, the ratio of the risk premiums of two assets is equal to the ratio of their
betas.

d. Company A has £10 million in debt and £40 million in equity. A comparable company B has £100
million in debt and £200 million in equity. The equity beta of company B is 1.4. If both companies
have a tax rate of 40%, zero debt beta, and follow a financial policy that implies a constant level
of debt, then the equity beta of company A is higher than 1.2.

6. (5 marks) Products Inc. is analysing a 5 -year project that produces sales of £100 million per year (in
years 1 through 5). Under the assumption that accounts receivable are 10% of current year sales, the
project has a positive NPV of £5 million. However, the management is concerned that customers will
pay at a slower rate, which will put accounts receivable for the project at 20% of current year sales.
The project’s discount rate is 10%. The NPV of the project under this alternative scenario is closest to

a. £1.55 million
b. £4 million
c. £2.7 million
d. Not enough information is provided

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Part 2: Answer all questions. Explain all your answers.

7. (10 marks) The figure below plots the historical average return against the historical volatility for large
portfolios and for 500 individual stocks.
a. (5 marks) Explain why there is a clear positive relationship between volatility and return for
large portfolios but not for individual stocks.

b. (5 marks) Suppose you would like to invest in world stocks generating an expected return of
10%, but do NOT have access to so many different capital markets. However, you can invest
in the S&P 500 (expected return of 12%) and Treasury Bills (expected return of 4%). Can you
construct a portfolio from the S&P 500 and Treasury Bills to replicate the expected return of
the world stocks?

8. (15 marks) You have been hired by a company to provide advice on capital structure decisions. One
day the CEO puts forward the following arguments to you:
a. I have estimated a cost of debt of 4% and a cost of equity of 15% for my firm. As debt is
“cheaper” than equity, I would like to issue a bond and buy back shares to reduce the overall
cost of capital of my firm.
b. The leverage from the bond issuance will increase my firm’s expected earnings per share
(EPS) which should lead to an increase in the firm’s stock price. That will benefit all
shareholders, including myself, since I own 5% of the shares.
Assuming perfect capital markets, do you agree with the CEO’s arguments? Explain your reasoning.

9. (20 marks) You are managing an all-equity firm that has 1 million shares outstanding in year 0. The
firm has fixed assets with value A, which is constant over time. As the manager, you know the value
of A but investors only learn it in year 3; as a result, the market price of shares in year 3 will reflect the
value of A.

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 In addition to the fixed assets, the firm has (i) £1 million of excess cash at year 0, deposited in a non-
interest-bearing bank account, and (ii) the opportunity to invest £11.5 million in year 2 in a project that
subsequently yields £11.9 million in year 3. Therefore, in order to invest in the project, the firm needs to
raise additional funds of £10.5 million.

Your objective is to maximize the firm’s share price in year 3.

a. (10 marks) Assume that you can raise £10.5 million by issuing new shares at a price of £8.11 per share
before making the potential investment in year 2. If the value of the firm’s fixed assets is A = £12 million,
would you issue shares and invest in the project or not? What if A = £6 million?

b. (10 marks) Now assume that an investment banker informs you that you could use the £1 million of excess
cash to repurchase shares at a price of £11.55 per share in year 1, and then raise the full £11.5 million
needed to invest in the project by issuing new shares at a price of £8 per share in year 2. If the value of
the firm’s existing assets A = £12 million, which of the following alternatives would you choose: (i)
repurchase shares in year 1 and then do nothing in year 2, (ii) repurchase shares in year 1 and then issue
new shares and invest in the project in year 2, (iii) do nothing in both years. How would your answers
change if A = £6 million? What if A = £9 million?

10. (25 marks) You have the following information about a company.

• Sales in 2019 were £2000 million. Sales are expected to grow at a rate of 15% in 2020, and
afterwards the growth rate will drop to 3%.

• EBIT margin is expected to stay constant at 15%.

• The corporate tax rate is 40%.

• Net working capital each year is expected to stay constant at 10% of next year's sales.

• To generate sales growth, each year t, capital expenditure net of depreciation (i.e., Capex-
Depreciation) is expected to be 1/3 of the sales increase from year t to year t+1.

• The debt-to-equity ratio (D/E) of the company is expected to stay constant at 1/2 and its equity cost
of capital is 15%.

• The firm has perpetual bonds outstanding with a coupon rate of 9% paid annually. The bonds are
currently selling at par and have a AAA credit rating.

a. (8 marks) Estimate the after-tax weighted average cost of capital (WACC) of the company.
b. (10 marks) Compute the value of the company at the beginning of 2020 using the WACC
method. You may assume that all cash flows occur at the end of each year.

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 c. (7 marks) Assuming that at the beginning of 2020 the company’s balance sheet had £100 million
in excess cash and £200 million in long-term debt, find the company’s stock price if the company
has 100 million shares outstanding.

Formulas

1. Unlevering equity betas if i) firm has constant leverage ratio and ii) debt is risk free.
𝛽"
𝛽! =
𝐷
1+𝐸

2. Unlevering equity betas if i) firm has constant debt level and ii) debt is risk free.
𝛽"
𝛽! =
𝐷
1 + (1 − 𝑡) 𝐸

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