2009 Exam Finance

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    COLLEGE OF HUMANITIES & SOCIAL SCIENCETHE UNIVERSITY OF EDINBURGH BUSINESS SCHOOL

    FULL-TIME MBA/MBA IN INTERNATIONAL BUSINESS/DIP BADEGREE EXAMINATION

    (EXAMINATION TO BE MARKED ANONYMOUSLY)

    FINANCE

    (COMPONENT OF MANAGEMENT KNOWLEDGE 1)

    Monday 7 December 20092:30pm 4:30pm

    Chairman of Board of Examiners: Mr S EarpExternal Examiner: Professor Ian Tonks

    Each Question (1 and 2) comprises one half of the exam, counts for 100 marks and shouldtake approximately 60 minutes to answer

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    Question 1

    Part AGuideline 30 Minutes

    EUBS, an educational business, is concerned about the falling rate of growth in its sector. Tohelp you analyse their business prospects, their accountant constructs the followings ratiosfor the years 2000-4:

    2000 2001 2002 2003 2004

    Profit Margin % 13.68 14.76 16.2 18.6 20.04

    Retention Rate % 91.3 91.9 92.8 92.2 86.6

    Asset Turnover 73.04 73.52 74.24 73.76 69.28

    Assets (end of year) 2436 3118 3681 4923 5483Equity (end of year) 1406 1756 2233 2958 3219

    Growth rate in Sales 17.8 16.4 21.4 14 8.5

    a) Calculate EUBS sustainable growth rate for each year.Out of 20 Marks

    b) Does EUBS have a growth problem? If so, what tools are available to management tomanage the problem?

    Out of 10 marks

    c) Discuss fully what management should do with the financial and operational tools atits disposal make detailed and specific recommendations.

    Out of 20 Marks

    (Overall out of 50 Marks)

    Part BGuideline 30 Minutes

    Interest rates have never been lower so lets borrow everything we can get our hands onproposes Sam the bosss son. He adds Additionally, our debt ratio ( at 70%) is already abovethat of all our competitors (who are at 50%) so by utilising financial leverage we can begin

    to use debt to provide really exceptional returns to our equity shareholders.

    As a new member of the board you are required to clearly (and respectfully) sketch atheoretical framework to help your fellow board members understand what happens to thecost of capital (debt and equity) when increasing amounts of debt is raised, and in particularwhat happens when your company moves above the gearing for your peer group.

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    Question 2

    Part AGuideline 20 Minutes

    A company wishes to raise $800 million in a new share issue.

    Your investment banking advisor suggests that the sale to the market will require a little bit ofunder pricing, say 8 percent with a 7 percent spread. (He mutters that the under pricing is 8percent of the current stock price and the spread is 7 percent of the issue price).

    a) Assuming that the companys share price is expected to increase prior to issue dateby 20 percent from its current $75 per share, how many shares must the company

    sell and at what price to the company?

    b) How much money will the investment banking advisor earn on the sale?Discuss with reference to the pricing of the issue whether management should usedebt markets or equity markets to raise capital?

    c) Is the 8 percent under pricing a cashflow? Is it a cost? If so, to whom?

    Out of 34 Marks

    Part BGuideline 20 Minutes

    The return an investor earns on a bond over a period of time is known as the holding periodreturn (HPR), defined as interest income, plus or minus the change in the bond price (dividedof course by the beginning bond price)

    a) Based on the logic above what is the HPR on a bond with a par value of $1,000, acoupon rate of 7 percent if its price at the beginning of the year was $1,060 and itsprice at the end was $920. Assume interest paid annually. Discuss fully what featuresthe bond could have added to it to make it more attractive to investors.

    b) Explain fully two possible reasons why the bond value may have fallen during theyear?

    Out of 33 Marks

    Part CGuideline 20 Minutes

    A developer of the infamous Halfamiledevelopment in Edinburgh has been trying to shiftpenthouse flats by offering these flats for sale at 120,000 - on the basis of 20,000 downand then 20,000 at the end of the next five years with no interest to be charged.

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    FINANCIAL ARITHMETIC

    FVt = future value at timeintdex T

    PV = present value r= interest rate CF = cash flow

    Future value of interest factor(FVIF) at r% and to time t

    ( )ttr rFVIF += 1,

    Present value ofinterest factor (PVIF) atr% from time t

    ( )ttr

    rPVIF

    +=

    1

    1,

    Present value interest factorof an annuity (PVIFA) at r%and n periods

    ( )

    +=

    nnrrrr

    PVIFA1

    11,

    Future value at time t andinterest rate, given presentvalue

    ( ) tt

    FVrPV =+ 1

    Present value givenfuture value at time tand interest rate

    ( )tt

    r

    FVPV

    +=

    1

    Present value of an annuity ofperiodic payment amount CFat r% and n periods

    ( )

    +=

    nrrr

    CFPV1

    11

    Alternative way of derive the present value of periodic paymentamount PMT at r% and n periods:

    niPVIFArPMTPV ,=

    Present value of a perpetuity with periodicpayment CF1 at interest rate r%

    r

    CFPV 1=

    Present value of a growth perpetuity with firstpayment CF1 and growth rate g at interest rate r%

    gr

    CFPV

    = 1

    CAPITALBUDGETING

    k =required rate of return or opportunity cost of capital

    Net present value calculation

    ( )= +

    +=n

    tt

    t

    k

    CFINPV

    10

    1

    Benefit-Cost NPV

    ( ) ( )CostPVvenuePVNPV = Re

    Profitability index or benefit-cost ratio

    ( )0I

    PVratioCBindexPI =

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    BOND VALUATION

    Cpn = coupon Prin = principal y= yield on bond

    Value of a bond

    ( ) ( )mmBond

    y

    in

    yyyCpnV

    ++

    +=

    1

    Pr

    1

    11

    Value of a bond

    ( )= +

    =m

    tt

    tBond

    y

    CFV

    1 1

    EQUITY VALUATION

    Dividend growth model Required return on share

    gk

    DP

    = 10 g

    P

    Dk +=

    0

    1

    Capital gains yield on a share (common stock) Dividend yield on a share (common stock)

    ( )

    1

    1

    = t

    tt

    P

    PP

    yieldgainsCapital 1= t

    t

    P

    D

    yieldDividend

    WEIGHTED-AVERAGE COST OFCAPITAL

    (WACC)

    Weighted average cost of capital (WACC) calculation

    EquityDebt kED

    EkED

    DWACC+

    ++

    = E = market value of equityD = market value of debtK equity = required return on equityK debt = required return on debt

    After tax WACC TC = corporate tax rate

    ( ) EquityCDebt kED

    ETk

    ED

    DWACC

    ++

    += 1

    CAPITAL STRUCTURE AND RISK AND RETURN SHARING

    Effect of financial leverage on risk of the firm (asset)

    ED

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    RATIOS

    equityrsShareholde

    incomeNetequityonturn

    'Re =

    Assets

    incomeNetassetsonturn =Re

    equityrsShareholde

    Assets

    Assets

    Sales

    Sales

    incomeNetequityonturn

    'Re =

    Assets

    Sales

    Sales

    incomeNetassetsonturn =Re

    SalesprofitGrossinmGross =arg

    SalesincomeNetinmprofitNet =arg

    inventoryEnding

    soldgoodsofCostturnoverInventory =

    daypersalesCredit

    receivableAccountsperiodCollection =

    dayperSales

    uritiesandCashcashinsalesDays

    sec=

    dayperSales

    uritiesandCashcashinsalesDays

    sec=

    dayperpurchasesCredit

    payableAccountsperiodPayables = equipmentandplantpropertyNet

    SalesturnoverassetFixed

    ,,=

    equityrsStockholde

    AssetsratioleverageFinancial

    '=

    incomeNet

    DividendsincomeNetratiotention

    =Re

    assetsTotal

    sliabilitieTotalratioassetstoDebt =

    ( )EquitydebtbearingInterest

    rateTaxEBITcapitalinvestedonturn

    +

    =1

    Re

    +=

    =

    rateTax

    repaymentincipalInterest

    EBITeredburdenTimes

    enseInterest

    EBITearnederestTimes

    1

    Prcov

    expint

    assetsCurrentratioCurrent =

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    ( )

    PRAT

    EquityEarningsRR

    Equity

    equityinChangeggrowtheSustainabl

    bop

    bop

    =

    =

    =*

    ( )E

    DiROICROICROE '+=

    outflowcashTotal

    lowcashaverageAnnualreturnofrateAccounting

    inf=

    ( )investment

    capitalWorking

    enditures

    CapitalonDepreciatiTEBIT

    flowcash

    Free+=

    exp1

    W

    T

    K

    FCF

    firmgrowthnoof

    valuealTer1

    min += gK

    FCF

    firmgrowingyperpetuall

    ofvaluealTer

    W

    T

    = +1

    min

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