Foundations of Finance Handbook 12-13

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School of Economics, Finance and Business

MODULE CODE: ECOS 1011MODULE NAME: FOUNDATIONS OF FINANCE

October 2012

PLEASE RETAIN THIS HANDBOOK FOR FUTURE REFERENCE. IT MAYBE REQUIRED FOR SUBMISSION TO PROFESSIONAL BODIES WHENAPPLYING FOR EXEMPTION FROM EXAMINATIONS.


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1. Contents

1. Contents ................................................................................................................ 2

2. Teaching Staff ....................................................................................................... 3

3. Module Information ............................................................................................... 3

4. Delivery Mechanisms ............................................................................................ 4

5. Summative Assessment ....................................................................................... 4

6. Formative Assessment ......................................................................................... 4

7. Classes ................................................................................................................. 5

8. Assessment Criteria .............................................................................................. 5

9. Seeking Help ......................................................................................................... 6

10. Duo ..................................................................................................................... 6

11. Textbooks ........................................................................................................... 7

12. Module Syllabus .................................................................................................. 8

13. Class Sheets ..................................................................................................... 12Sheet One .................................................................................................................. 12Sheet Two .................................................................................................................. 13Sheet Three ............................................................................................................... 15Sheet Four ................................................................................................................. 17Sheet Five .................................................................................................................. 19Sheet Six .................................................................................................................... 21

Sheet Seven .............................................................................................................. 23Sheet Eight ................................................................................................................ 25Formative Seminar ..................................................................................................... 26

N.B. This handbook is intended for the guidance of students taking this module in2012/2013. Whilst the details contained in this handbook represent teaching staffintentions at the time of writing, it is in the nature of higher education that somemodule information, such as syllabus, reading lists and assignments, may be subjectto modifications during the teaching of a module. Teaching staff reserve the right to

make such minor changes in the matters covered by this publication and willendeavour to publicise any such changes as widely and timely as possible.


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2. Teaching Staff

Lectures Dr Toby Watson (Module Leader)

0191 33 46338/40146

[email protected]

Mr Michael Lucey

0191 33 40110

[email protected]

Class Tutors Mr Ratnam Vijayakumaran

[email protected]

Mrs Sunitha Vijayakumaran

[email protected]

Office hours will be posted on DUO.

3. Module Information

The following information is included in the Module Outline, which is available athttp://www.dur.ac.uk/faculty.handbook/module_description/?year=2012&module_code=ECOS1011:

Prerequisites and corequisites (where appropriate)

Module Aims

Learning Outcomes, including subject-specific knowledge, subject-specific skillsand key skills.


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4. Delivery Mechanisms

Number Frequency Duration

Lectures 38 2 per week (double lecture)

1 hourRevision Lectures 4 In the Easter term

Classes* 9 Across the three terms

Classes, of which there are nine throughout the year, provide a structuredprogramme of work designed to reinforce knowledge and encourage independentstudy. Eight of the classes are tutorials and the questions for these are shown later inthe handbook. The remaining class is a seminar and will be used for the formative

group presentations. All students are expected to have read about the subject of thepresentations and to be prepared to enter into discussion of the issues.

* Students will be provided with details of the precise split of the classes over theterms.

5. Summative Assessment

This module is summatively assessed by means of an examination inMay/June. You should refer to the Programme Handbook (see the section

"Assessment of Performance") for information on how we mark.

Past exam papers are available for your consultation on Duo via the Library tab, butsolutions/model answers will notbe provided.

6. Formative Assessment

The main aim of the formative assessment is to help you, in a structured way, tounderstand the material and its applications, consolidate your knowledge and furtherdevelop relevant skills.

Students will undertake two formative assessments during the year. The first will be agroup presentation near the beginning of the Epiphany term, the second a multiplechoice test delivered via Duo near to the end of the Epiphany term.

An outline of the requirements for the group presentation are given on page 26. Moredetails of the group presentation, as well as the seminar class in which it is to takeplace, will be provided nearer the time. The formative test will be administered viaDuo and students will receive full details in the Epiphany term.


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7. Classes

Non-lecture classes, of which there are nine throughout the year, are designed togive students the opportunity to explore issues in depth and to enter into discussionand debate on issues in finance. Questions for the classes are shown later in thishandbook.

All students are expected to prepare answers to all questions for each class

and to be prepared to enter into discussion of the issues. In each class arandom sample of work from a number of students will be collected; this will

be marked and returned in the next class.

The tutor in charge of the class will take a lead, but students are expected to makemajor contributions. Attendance at all classes is compulsory. You must attend thegroup which you have been allocated to, unless there are circumstances beyondyour control that prevent this such as illness. In such cases, check with the seminartutor as soon as possible to ensure there is space in an alternate group. You mustalso notify the programme office.

8. Assessment Criteria

Performance in the formative and summative assessments for the module is judgedagainst the following criteria:

Relevance to question(s)

Organisation, structure and presentation

Depth of understanding

Analysis and discussion

Use of sources and referencing

Overall conclusions

!


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9. Seeking Help

All members of the teaching team will have consultation hours where they will bepleased to talk to students. The days/times of consultation hours will be posted onDuo. If you wish to ask questions about the material you should first talk to yourseminar tutor in their consultation hour and, where appropriate, the consultation hourof the lecturer delivering that part of the module. Normally, your tutors will expect youto have devoted some study time to addressing problems yourself first and they willwant to ascertain your understanding (e.g. rather than simply providing answers tonumerical problems). Seminars also provide a good opportunity to discuss anyquestions you might have with your peers and the seminar leader.

Overall problems, general enquiries or concerns relating to the module should bebrought to the attention of the Module Leader as soon as possible.

If you have serious problems that relate more generally to your studies across thisand other modules please see the Programme Handbook for guidance. In suchcases, you should normally see your Course Leader or, for issues relating toassessment, the Chair/Deputy Chair of the Board of Examiners. However, full detailsof the support mechanisms that are in place are available in the ProgrammeHandbook.

10. Duo

Teaching staff will place information on Duo as appropriate. All students areexpected to consult the modules Duo site regularly.

Whilst some lecture notes and other useful/supporting information may be placed onDuo (in advance where applicable), students should note that this material isintended as a useful complement to, and not a substitute for, attendance at lectures.In particular, not everything covered in lectures will be available on Duo. Theteaching team may also choose to use the whiteboard and/or visualiser to presentelements of topics, for example building up diagrams whilst discussing the meaning,so as to aid student understanding. Other examples might include working throughnumerical examples step-by-step. Naturally, students are expected to take notes assuch material will not normally be replicated on Duo.


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11. Textbooks

There are many excellent introductory textbooks, all of which cover much the samematerial. It is expected that students will purchase one of these books, since bypurchasing one text easy access to at least one essential source of material isguaranteed. It is also vital, and cannot be overstressed, that lecture material issupplemented through consulting a variety of different sources.

Essential reading is identified below, with the module being most closely based onthe text by Keown, Martin and Petty. Boakes provides a good linkage to the realworld there are many articles in the text that you can relate to the theoreticalconcepts covered in lectures. Many seminars have one or more questions derivedfrom articles presented in Boakes.

You should also undertake your own search for additional relevant literature andfollow up relevant references contained in the literature identified below. It is alsohighly recommended that you read the financial press on a regular and frequentbasis to gain an understanding of how theory relates to practice.

Core Texts

Keown, A.J., Martin, J.D. and Petty, J.W. (2010) Foundations of Finance. 7thinternational edn. Pearson Prentice Hall.

Boakes, K. (2010) Reading and Understanding the Financial Times. 2nd edn.Financial Times Prentice Hall.

NOTE: Boakes is also available as an online e-book via the Library catalogue athttp://library.dur.ac.uk/record=b2616122~S1 accordingly, you may decide you wishto read this electronically rather than purchasing a copy.

Other Excellent Texts

Brealey, R.A., Myers, S.C. and Marcus, A.J. (2008) Fundamentals of CorporateFinance. 6th edn. McGraw-Hill.

McLaney, E. J. (2011) Business Finance: Theory and Practice. 9th edn. FinancialTimes Prentice Hall [This text is available as an e-book from the Library web site:

http://library.dur.ac.uk/record=b2719466~S1 ]

Pike, R. and Neale, B. (2006) Corporate Finance and Investment. 6th edn. FinancialTimes Prentice Hall.

Ross, S.A., Westerfield, R.W. and Jordan, R.D. (2010) Fundamentals of CorporateFinance. 9th edn. McGraw-Hill.

Van Horne, J.C., and Wachowicz, J.R. (2008) Fundamentals of FinancialManagement. 13th edn. Pearson Prentice Hall.


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12. Module Syllabus

Essential reading is identified below. Additional references will be provided duringthe year.

1. An Introduction to Finance

What is finance about? The importance of financial decisions. An introduction tosources of long-term funds. Forms of business organisation. The financial objectivesof the corporation.

McLaney, Chapters 1 and 2.Keown, Martin and Petty, Chapter 1.Brealey, Myers and Marcus, Chapter 1.Ross, Westerfield and Jordan, Chapter 1.Van Horne and Wachowicz, Chapter 1.

2. Basic Mathematics of Finance

An introduction to the mathematics of finance. The time value of money. Future andpresent values of cash flows. Compounding and discounting.

McLaney, integrated but esp. pages 78-84.Keown, Martin and Petty, Chapters 2 (pages 35-39) and 5.Brealey, Myers and Marcus, Chapter 4.Ross, Westerfield and Jordan, Chapters 5 & 6.Van Horne and Wachowicz, Chapter 2.

3. Sources and Valuation of Long-term Funds

The role of capital markets. The characteristics of loan capital. The advantages anddisadvantages of long-term debt financing. The characteristics of equity capital. Theadvantages and disadvantages of equity financing. Valuing shares: the basic sharevaluation model; discounting dividends; the constant dividend formula; the dividendgrowth model. Valuing debenture stock: nominal yield; current yield; the yield tomaturity.

Keown, Martin and Petty, Chapters 7 and 8.Brealey, Myers and Marcus, Chapters 5 and 6.Ross, Westerfield and Jordan, Chapter 7 and 8.

Van Horne and Wachowicz, Chapter 4.Boakes article 21.


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4. Investment Appraisal under Certainty

The importance of the investment decision. The role of investment appraisaltechniques. The payback method. The accounting rate of return method. The netpresent value (NPV) approach. The internal rate of return (IRR) method. NPV andIRR compared.

Keown, Martin and Petty, Chapter 10.McLaney, Chapter 5Brealey, Myers and Marcus, Chapters 7 and 8.Ross, Westerfield and Jordan, Chapters 9, 10 and 11.Van Horne and Wachowicz, Chapters 12 and 13.Boakes article 24.

5. Investment Appraisal in Practice

Relaxing the assumption of full knowledge. Data requirements. Inflation andinvestment appraisal. Risk and uncertainty: the risk-adjusted discount rate; theexpected net present value method; sensitivity analysis; game theoretic approaches.Controlling the investment process. The use of investment appraisal techniques.

Keown, Martin and Petty, Chapter 11.McLaney, Chapter 6Ross, Westerfield and Jordan, Chapter 11.

A. Sangster, (1993) 'Capital Investment Appraisal Techniques: A Survey of CurrentUsage', Journal of Business, Finance andAccounting, pp. 307-332.Van Horne and Wachowicz, Chapter 13.R. Pike (1996) 'A Longitudinal Survey on Capital Budgeting Practices', Journal ofBusiness Finance and Accounting, pp. 79-92.G.C. Arnold and P. D. Hatzopoulos, (2000) The Theory-Practice Gap in CapitalBudgeting: Evidence from the United Kingdom, Journal of Business, Finance and

Accounting, pp.603-626.

6. Risk

Using basic quantitative methods to measure risk and expected return. Explainingthe concept of investment diversification. Distinguishing between systematic andunsystematic risk and explaining how systematic risk is measured.

Keown, Martin and Petty, Chapter 6.McLaney, Chapter 7.Bodie, Z., Kane, A. and Marcus, A. (2008) Essentials of Investments. 7th internationedn. McGraw-Hill, Chapters 5 & 6Brealey, Myers and Marcus, Chapters 10 & 11.Ross, Westerfield and Jordan, Chapters 12 & 13.Van Horne and Wachowicz, Chapter 5.


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7. The Cost of Capital

This component of the course will seek to investigate the cost to firms of raising thenecessary capital to fund investments. This includes explaining and calculating thecost of equity and debt capital and the weighted average cost of capital.

Keown, Martin and Petty, Chapter 9.McLaney, Chapters 10 & 11.Brealey, Myers & Marcus, Chapter 12.Ross, Westerfield & Jordan, Chapter 14.Van Horne and Wachowicz, Chapter 15.Boakes article 18.

8. Financing Decisions

This topic is focused on the practicalities of raising capital. Initial public and seasonedofferings of equity, rights issue and debt issues. There will also be a basicintroduction to capital market efficiency.

Keown, Martin and Petty, Chapter 2.McLaney, Chapters 8 & 9.Brealey, Myers & Marcus, Chapters 13 & 14.Bodie, Z., Kane, A. and Marcus, A. (2008) Essentials of Investments. 7th internationedn. McGraw-Hill, Chapters 3 and 8Ross, Westerfield & Jordan, Chapter 15.Van Horne and Wachowicz, Chapter 19.E. Fama, (1970), Efficient Capital Markets: A Review of Theory and Empirical Work,Journal of Finance, 25, pp. 383-417.Boakes articles 19 & 20..

9. An Introduction to Capital Structure

The debt-equity ratio. Leverage effects, financial distress and the cost of capital.

Keown, Martin and Petty, Chapter 12.Brealey, Myers and Marcus, Chapter 15.Ross, Westerfield and Jordan, Chapter 16.Van Horne and Wachowicz, Chapter 17.Boakes article 16 and those in Topic 5.

10. Dividends and Dividend Policy

What are dividends? The mechanics of paying dividends. Does dividend policymatter? Stock repurchases, stock dividends and stock splits.

Keown, Martin and Petty, Chapter 13.McLaney, Chapter 12.Brealey, Myers and Marcus, Chapter 16.Ross, Westerfield and Jordan, Chapter 17.Van Horne and Wachowicz, Chapter 18.Boakes article 16 and those in Topic 9.


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11. Financial Planning

How the firm can make use of the information from both financial statements andmarket prices to inform the financial decision making process?

Keown, Martin and Petty, Chapters 4 and 14.Brealey, Myers and Marcus, Chapters 17 and 18.Ross, Westerfield and Jordan, Chapters 3 and 4.Van Horne and Wachowicz, Chapters 6 and 7.E.I. Altman, (1968) Financial Ratios, Discriminant Analysis and the Prediction ofCorporate Bankruptcy, Journal of Finance, 23, pp. 598-609.

12. Working Capital Management

How the firm performs the daily management of its inventory, cash and credit.Models for determining optimal cash and inventory holdings.

Keown, Martin and Petty, Chapter 15 and 16.

McLaney, Chapter 13.Brealey, Myers and Marcus, Chapters 19, 20 and 21.Ross, Westerfield and Jordan, Chapters 19 and 20.Van Horne & Wachowicz, Chapters 8, 9 and 10.

13. International Financial Management

An introduction to the problems faced by financial managers when dealing withforeign exchange. How hedging can be used to reduce risk

Keown, Martin and Petty, Chapter 17.Brealey, Myers and Marcus, Chapter 23.

Ross, Westerfield and Jordan, Chapter 21.Van Horne and Wachowicz, Chapter 24.Boakes article 31.


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Seminar Class Sheets

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13. Class Sheets

Sheet One

Prior to the class all students should prepare answers to the following questions:

1. What are the three types of financial management decisions? For each type ofdecision, give an example of a business transaction that would be relevant.

2. What are the major disadvantages of the sole proprietorship and partnershipforms of business organisation? What benefits are there to these types ofbusiness organisation as opposed to the corporate form? Why are some soleproprietors unwilling to change the form of business organisation to the corporateform?

3. What is the primary disadvantage of the corporate form of organisation? Name at

least two of the advantages of corporate organisation.

4. Why do we assume that the goal of a private-sector organisation is to maximiseshareholder wealth?

5. Who owns a corporation? Describe the process whereby the owners control thefirms management. What is the main reason that an agency relationship exists inthe corporate form of organisation? In this context, what kind of problems canarise? Name some other areas of activity in which an agency relationship exists.

6. What is the difference between primary and secondary capital markets? Why isthe existence of secondary markets important?

7. Can the goal of maximising the value of shares conflict with other goals, such asavoiding unethical or illegal behaviour? In particular, do you think subjects likecustomer and employee safety, the environment and the general good of societyfit in this framework, or are they essentially ignored? Use some specific scenariosto illustrate your answer.

8. Consider Articles 2 and 3 together with the associated discussion in Boakes(pp.9-13).1 Come prepared to discuss these in the seminar and the followingpoints in particular:

a. Does the stepping down of Logicas chief executive seem consistent withthe goal of maximising shareholders wealth and directors running the firmas agents?

b. As Boakes asks: In what situations might we expect there to be asignificant increase in the number of activist shareholders in a company?

c. Discuss how company shareholders can encourage their managers toact in a way which is consistent with the objective of shareholder wealthmaximisation.

1Remember, Boakes is available as an e-book from the Library.


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Sheet Two


1. What is meant by the term the time value of money and why is it important?

2. Why is the concept of the present value superior to that of the future value forcomparing investment opportunities?

3. As you increase the length of time involved, what happens to future values? Whathappens to present values?

4. What happens to a future value if you increase the rate r? What happens to apresent value?

5. Use discount tables to show the present value of the following sums of money:

a. 150 to be received in 12 years when the discount rate is 10%

b. 275 to be received in 9 years when the discount rate is 8%

c. 5,500 to be received in 6 years when the discount rate is 16%

d. 4,250 to be received in 11 years when the discount rate is 14%

6. A company has the opportunity to undertake an investment costing 13,500which will generate net cash flows in each of the next seven years of 3,000. Usediscount tables to calculate the present value of the future cash flows:

a. when the discount rate is 7%

b. when the discount rate is 10%

c. when the discount rate is 18%

7. What is the present value of a perpetuity of 500 per annum when the discountrate is:

a. 9%

b. 18%

c. 24%

8. How does a bond issuer decide on the appropriate coupon rate to set on itsbonds? Explain the difference between the coupon rate and the required rate ofreturn on a bond.

9. Is the yield to maturity (YTM) on a bond the same thing as the required return? IsYTM the same thing as the coupon rate? Suppose today a 10 per cent couponbond sells at par. Two years from now, the required return on the same bond is 8per cent. What is the coupon rate on the bond at that time? What is the YTM?

10. Suppose you buy a 7 percent coupon, 20-year bond today when it is first issued.If interest rates suddenly rise to 15 percent, what happens to the value of yourbond (you do not have to provide a numerical value)? Why?


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11. Queen's Ltd has 6 percent coupon bonds on the market that have 12 years left tomaturity. The bonds have a face value of 100 and make annual payments. If theYTM on these bonds is 9 percent, what is the current bond price?

12. If Treasury bills are currently paying 8 percent and the inflation rate is 6 percent,what is the approximate real rate of interest? What is the exact real rate?


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Sheet Three


1. Why does the value of a share of stock depend on dividends?

2. A substantial percentage of the companies listed on leading stock exchangesdont pay dividends, but investors are nonetheless willing to buy shares in them.How is this possible given your answer to the previous question?

3. Under what two assumptions can we use the dividend growth formula todetermine the value of a share? Comment on the reasonableness of theseassumptions.

4. Martins plc has just paid a dividend of 0.30 per share on its stock. The dividendsare expected to grow at a constant rate of 5 per cent per year indefinitely. Ifinvestors require a 12 percent return on Martins plc, what is the current price?What will be the price in 3 years? In 15 years?

5. Consider Article 21 in Boakes (pp.114-116). The article says that Few analystsdiscounted cash flow valuations are above 400p. How can you reconcile thiswith the private equity bid of 585p and the stock price of 560p? How does a lowterminal growth rate influence the 400p valuation?

6. The next dividend payment by OBA Ltd will be 0.40 per share. The dividendsare anticipated to maintain a 6 percent growth rate forever. If OBA Ltd stockcurrently sells for 4.50 per share, what is the required return?

7. Smashed Pumpkin Farms (SPF) just paid a dividend of 0.45 on its stock. Thegrowth rate in dividends is expected to be a constant 7.5 per cent per year,

indefinitely. Investors require an 18 percent return on the stock for the first threeyears, an 11 percent return for the next three years and then a 12 percent returnthereafter. What is the current share price for SPF stock? (Hint: To answer thisquestion you must begin by calculating the price in year 6, then the price in year3, then the price now).

8. Lost Bearings Ltd. is a young start up company. No dividends will be paid on thestock over the next five years, because the firm needs to plough back its earningsto generate growth. The company will then pay a 0.60 per share dividend andwill increase the dividend by 5 percent per year, thereafter. If the required returnon this stock is 23 percent, what is the current share price?

9. What are the reasons why debt capital in a firm typically has a lower cost ofcapital than does equity capital in the same firm? Will debt capital in a firm alwayshave a lower cost of capital than equity capital in a different firm? Why or whynot?

10. Why is the investment decision of importance to firms?

11. Which of the following purchases would normally be considered to be worthy ofinvestment appraisal (explain your answer in each case):

a. buying a new computer system;

b. buying software for a computer;

c. purchasing a photocopier;


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d. purchasing supplies of paper for use in a photocopier;

e. building an extension to a factory;

f. refitting the company gym and social club;

g. undertaking a new advertising campaign?

12. What are the main stages of the investment decision making process?


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Sheet Four


1. Do investment appraisal techniques provide decision makers with decision advicethat they definitely should follow? Why or why not?

2. Concerning the payback:

a. Describe how the payback period is calculated and describe theinformation this measure provides about a sequence of cash flows. Whatis the payback criterion decision rule?

b. What are the problems associated with using the payback period as ameans of evaluating cash flows?

c. What are the advantages of using the payback period to evaluate cashflows? Are there any circumstances under which using payback might be

appropriate?

3. Concerning NPV and IRR:

a. Describe how NPV is calculated and describe the information thismeasure provides about a sequence of cash flows. What is the NPVcriterion decision rule?

b. Why is NPV considered to be a superior method of evaluating the cashflows from a project? Suppose the NPV for a projects cash flows iscomputed to be 2,500. What does this number represent with respect tothe firms shareholders?

c. Describe how IRR is calculated and describe the information this measureprovides about a sequence of cash flows. What is the IRR criteriondecision rule?

4. A project that provides annual cash flows of 400 for eight years costs 1500today. Use the NPV and IRR methods to determine whether this is a good projectif the required return in 6%. What if the required return is 22%? At what discountrate would you be indifferent between accepting the project and rejecting it?

5. What is the IRR of the following set of cash flows?

Year Cash flow ()

0 -1,300

1 400

2 300

3 1,200

6. For the cash flows in the previous question, what is the NPV at a discount rate ofzero percent? What if the discount rate is 10%? If it is 20%? If it is 30%?


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7. To what extent should accounting conventions be included in the investmentappraisal process?

8. Why should inflation be taken into account when appraising investmentopportunities?

9. In the presence of inflation, there are two interest rates: the nominal rate and thereal rate. Which should be used in the investment appraisal process?

10. Distinguish between risk and uncertainty.

11. Consider Article 22 and the associated discussion in Boakes (p.118). What is thedifference between business risk and financial risk and can you identify the risksthat appear to apply to Woolworths as presented in the article?

12. Outline the main problems associated with the use of the ENPV approach.

13. Explain the principle underlying the risk adjusted discount rate approach. Whymight the use of a higher discount rate to reflect increased risk be unwise insome circumstances?

14. Why is sensitivity analysis of assistance to decision makers appraisinginvestment opportunities?


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Sheet Five

This class will be held in a computer room. Your seminar tutor will provide guidanceand opportunities for discussion in the class, but you must at least attempt the tasksbelow prior to attending.

1. Prior to the class, download the Excel spreadsheet Class5.xlsx from Duo. On theworksheet Q1 in Class5.xlsx you will cash flows for two projects. Prior to theclass, attempt to construct appropriate formulae in relation to the six stepsdescribed on Sheet1 to find the NPV and IRR of the projects.

2. Which of the two projects is preferred under NPV and IRR? Are these the sameand, if not, why is this? Initially, see what happens when you vary the discountrate. To help investigate further, look at worksheet Q2. You are asked toconstruct a table of the NPVs of the two projects under discount rates from 0 to30%. Once you have done this plot curves for the NPVs of both projects on agraph. How does this help to explain any differences in the decision based onNPV and IRR?

3. A company is considering launching a new product and believes that the successof the project will depend upon the state of the economy over the next few years.It estimates that there are three likely states of the economy: boom, neutral andrecession and that the product will have a life of four years. On this basis, itestimates the net cash flows as shown worksheet Q3.

The likelihood of each state of the economy occurring is estimated to be:

boom: 0.25neutral: 0.4recession: 0.35

Using sheet Q3 in Class5.xlsx, construct appropriate formulae to answer thefollowing questions:

a. Calculate the NPV for each state of the economy, assuming a discountrate of 10%

b. Calculate the ENPV of the project.

4. In broad terms, why is some risk diversifiable? Why are some risksnondiversifiable? Does it follow that an investor can control the level ofunsystematic risk in a portfolio, but not the level of systematic risk?

5. You own a portfolio that has 600 invested in stock A and 1200 invested instock B. If the expected returns on these stocks are 13% and 22% respectively,what is the expected return on the portfolio? Perform the calculation using Exceland also confirm you can do this on paper using your calculator.


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6. Assume the returns on shares of Pear Computers and Banana InformationSystems over the next year are contingent on the state of the world given below.

State of World Probability Pear Banana

1 0.2 6% 14%

2 0.3 10% 10%

3 0.5 10% -2%

This data is shown in worksheet Q4. Set up appropriate formulae to calculate theexpected return, variance and standard deviation of returns on an equally weighted

portfolio of the two shares.

7. A stock has an expected return of 17%, its beta is 0.9, and the risk-free rate is7.5%. What must the expected return on the market be?

8. Stock Y has a beta of 1.59 and an expected return of 25%. Stock Z has a beta of0.44 and an expected return of 12%. If the risk-free rate is 6% and the market riskpremium is 11.3%, are these stocks correctly priced? Can you set up a chart toplot the SML?


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Sheet Six


1. Explain why the cost of capital and required return may be regarded as twosides of the same coin.

2. Cunningham and Reilly Crane Hire plc has common stock with an ex dividendmarket price of 0.70 per share and a constant expected annual dividend growthrate of 5%. A dividend of 0.10 per share has just been paid. Calculate C & R'scost of equity capital.

3. Steyn & Nel plc has preferred stock trading at 65. The annual dividend on thepreferred stock is 2.80 per share. What is the cost of Steyn & Nels preferredstock?

4. Manic Sweet Peaches plc has 500,000 shares of common stock outstanding and50,000 bonds outstanding. The stock is trading at 7.50 per share and the cost of

equity is 12%. The face value of a bond is 100 and the debt is selling at 110% ofpar with a yield to maturity of 9%. The rate of corporation tax is 31%. CalculateMSPs WACC.

5. Gausden & Bennison Ltd. need to raise 7.5 million to start a new project. Thecompany has a target capital structure of 60 % common stock, 10 % preferredstock, and 30% debt. Flotation costs for issuing new stock are 15%, for newpreferred stock, 7%, and for new debt, 4%. What is the true initial cost figure G&Bshould use when evaluating its project?

6. The Rock Bottom Pub Company Limited are considering opening a new super-pub in Thornaby. The cost of the project will be 700,000 and it is expected to

generate net cash flows of 120,000 per year in perpetuity. The company has atarget debt/equity ratio of 1, a flotation cost of debt of 6%, a flotation cost ofequity of 12%, a yield-to-maturity of 9% and a required return on equity of 15%.The rate of corporate taxation is 30%. Should the firm proceed with the project?

7. Under what circumstances is the WACC an appropriate measure of the discountrate for a project? Are these circumstances likely to hold in practice?

8. Ordinary shares of Jack Rabbit Slim Ltd. are currently quoted at 3 each. JRSannounce a rights issue where each existing shareholder is given the right topurchase one share at 1.75 for each five shares held. Mr Wallace currentlyholds 10,000 shares in JRS.

a. How many shares is Mr Wallace entitled to buy at the new price?

b. What is the ex-rights share price?

c. Assuming he exercises his rights, what is the total value of his newshareholding?

d. What is one right worth?

e. Mr Vega, who holds 1,000 shares, does not exercise his right; what is hisholding now worth?

9. Explain how a rights issue differs from a general cash offer.


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10. Tony Rocky Horror Meat Pies plc wants to raise 2.35m via a rights offering. Thecompany currently has 250,000 shares of common stock outstanding that sell for30 per share. Its underwriter has set a subscription price of 25 per share andwill charge TRHMP a 6% spread. If you currently own 5,000 shares of stock inthe company and decide not to participate in the rights offering, how much moneycan you get by selling your rights?

11. Honeybunny plc needs to raise 12m to finance an expansion into new markets.A general cash offering of new shares of equity will be undertaken to raise therequired funds. If the offer price is 22 per share and the company's underwriterscharge an 8% spread, how many shares need to be sold?

12. Pumpkin plc has recently gone public. Under a firm commitment agreementPumpkin receives 14 for each one of the 1.5 million shares sold. The initialoffering price was 15 per share, and the stock price rose to 17 per share in thefirst few minutes of trading. Pumpkin paid 250,000 in direct legal and othercosts, and 100,000 in indirect costs. What was the flotation cost as apercentage of funds raised?

13. Flock of Seagulls Inc. has 100,000 shares of stock outstanding. Each share isworth $75, so the company's market value of equity is $7,500,000. Suppose thefirm decides to issue 25,000 new shares and considers the following offeringprices: $75, $50, and $25. What will the effect be of each of these alternativeoffering prices on the existing price per share?

14. Read Articles 19 and 20 and the associated discussion in Boakes (p.109).According to Article 20, Hargreaves Lansdown shares opened at 160p and roseto close at 209!p, adding 232.4 m in value" Think about the following pointsand come prepared to discuss them in the seminar:

a. Why might the shares have risen in value so much on the first day?

b. How does this rise in price reflect on the indicative pricing range of140-160p?

c. What kind of cost does this rise in price represent?


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Sheet Seven


1. A trader at Megabank is convinced that by studying price charts for stocks he canmake consistent profits. Act as an advocate of market efficiency and explain whyyou do not believe him. Another trader studies company fundamentals and claimsto make consistent abnormal profits what form of the EMH does this violate?

2. According to Modigliani and Miller, what happens to cost of equity as leverageincreases (and why does this happen)?

3. Corp on the Cob currently has a market value of 3.5m, with 175,000 sharesoutstanding and no debt. The board of directors proposes a plan to change thefirms capital structure, whereby 1m of 10% irredeemable debt will be issuedwith the proceeds used to buy back stock. Corp on the Cob faces a 30%corporate tax rate.

Calculate the new market value of the firm if the directors implement theirproposed capital restructuring. To put this in perspective, also shown the old andnew share price. Assume that the costs of financial distress do not change.

4. Askew Corp. has a market value of 35m and is financed solely by equity, wherecost of equity is currently 20%. The directors wish to change the capital structureand are planning to issue 8m of 10% bonds. Higgins plc faces a coporate taxrate of 30%.

Assume that (1) the MM assumptions hold in a world with taxes; how will replacingthe equity with debt change Askews:

a. Market value?b. WACC?

5. Why do agency costs arise between equity holders and bondholders? Whataction might bond holders take to protect themselves?

6. Barstow plc faces a cost of capital of 20%. It is a well-run business which made25m profit last year, all of which was paid as a dividend. The directors expectprofits to continue to be 25m/year for the foreseeable future. However, thedirectors have now identified an investment opportunity which will cost 25m andresult in a pay-off in three years. This 25m would be found by not paying thedividend for one year only. What dividend would need to be paid in three years

for shareholders to be indifferent between management paying out a dividend orinvesting?

7. A firm currently pays out the majority of its earnings as a dividend. The directorswant to change this and pay out only a small dividend. Will this chance bedetrimental to shareholders? Consider this in relation to MMs arguments.

8. Read the article and associated discussion on MyTravel plc in Boakes (2010, pp.90-93). Prepare to discuss the article and the following points in particular:

a. The notion of shareholders as shock absorbers what does this mean inthe case of MyTravel?


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b. Convertible bondholders voted on whether to accept the proposal toreceive shares which effectively equal just 30% of the initial investment.Why would these bondholder vote for this?

9. Read the article and associated discussion on share buy-backs vs dividends inBoakes (2010, pp. 150-154). Prepare to discuss the article and the following

points in particular:

a. How do investors benefit from a share buy-back?

b. Would you prefer a firm you invest in to pay you a dividend or undertake ashare buy-back?

10. Read the article and associated discussion on De La Rue in Boakes (2010, pp.155-157). Prepare to discuss the article in class and address the followingquestions from Boakes:

a. It is often said that the dividend announcement made by a company is an

important source of information about the future prospects for thebusiness. In this case what signal is being given by De La Rue plc in thedecision to raise the annual dividend by 12.4 per cent and in addition toannounce a special one-off dividend of 46.5 p?

b. How else could the company have used this spare cash?


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Sheet Eight


1. Explain the three motives for firms to hold liquid reserves. Give an example toillustrate each motive.

2. Why may shareholders be concerned if the firm is holding a large quantity ofcash?

3. What are the pros and cons of a liberal credit policy? What are the pros and consof a stringent credit policy?

4. List the costs which vary directly with inventory levels and those which varyinversely with inventory levels.

5. One definition of net working capital says it is 'the excess of current assets overcurrent liabilities'. Another defines it as ' the component of current assets which is

financed out of long-term sources'. Are these two definitions the same? Explain.

6. The Homerjay Corporation is investing in the development and initial productionof a new beer flavoured doughnut. The project lasts for three years and has totaloutlays of 1.5m per year. The fixed transaction cost is 150 and the interest rate5 per cent per annum. Using the Baumol model calculate the optimal amount ofcash that Homerjay should withdraw.

7. What would happen to the above optimal cash withdrawal if the fixed transactioncost were to increase to 200? What would then happen if the interest rateincreased to 7 per cent?

8. Nine Inch Nails Ltd needs 2.5m a year for cash outlays. The relevant short-terminterest rate is 6 per cent and the fixed transaction cost for withdrawing cash is115.50. What is the optimal size of the cash withdrawal? How often will cash bewithdrawn?

9. Fatima Mansions Ltd have ordered their annual quantity of guttering. Fullpayment is required within 30 days, but a 2% discount is offered if the account issettled within 10 days. FMs cost of capital is 8 per cent. What should it do?

10. Green Day Drugstores Ltd. sells 2,500 boxes of an expensive drug per year. Theprice per box is 100, and variable inventory costs amount to 20 per cent of theprice of the box. The fixed cost per order is 10. How many boxes should beordered at a time? How many orders will be made per year?


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Formative Seminar

One of the classes in the Epiphany term will be a seminar in which you will be invitedto give a 10-minute presentation on a company listed in the FTSE 100 stock index.The purpose of this is to help you to:

Become used to bibliographic search

Find information from electronic sources

Examine company accounts

Pursue independent learning

You will work in groups and each group will be given a number corresponding to theranking of a company within the index. Your task will be to provide a generaldescription of the company from both an economic and a financial perspective. So,you should be able to identify the market sector the company is in and explain its

main activities. You should also be able to explain the important financial aspects ofthe company such as its share price, debt to equity ratio, dividends and earnings.You should attempt to identify five major factors (internal or external) that have hadan impact on the company in the past year. You could also compare your companysperformance with that of the sector and/or the market as a whole.

Groups of students and the ranking number of your company, and the date of yourpresentation, will be allocated during the class programme.

More details will be posted on Duo.

Documents

Foundations of Finance Handbook 12-13