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Question 1: Capital Expenditure Decision and Investment Criteria
The board of di rectors of Newton plc has to decide whether or not to invest in a manufactur ing plant to produce a new product that has been developed on the basis of research under taken wi thin the company. The development of the product has been expensive and at a cost of £2.00 million has significantly exceeded the initial budget allocation for the product. One member of the board has argued that the company should not proceed with the investment as it is most unlikely that it will be able to recover what has already been spent on the product.
The marketing department has suggested that the product should be sold at £14.00 per unit and it is anticipated that sales in the first year will be about 400,000 units, rising to 600,000 in year two. Sales are expected to remain at this level for the following three years and fall to 300,000 units in year six. It is thought that the product is unlikely to be competitive after six years given the rate of product innovation in the sector, and it will be withdrawn from the market at this stage.
To manufacture the product an investment of £9.00 million will be necessary in new production facilities. This expenditure can be written off for tax purposes using a 25 per cent writing down allowance. The re-sale value of the equipment has been estimated to be about £2.50 million at the end of the six year anticipated product life. Use will also be made of some equipment the company already owns. This equipment is now fully depreciated for tax purposes, but would be sold today for £1.20 million. If used in the manufacture of the product its value expected to fall to £0.30 million by the end of year six.
The production facility will be located in one of the company's factories that is not being fully utilised. The company has no alternative uses available for this space that is currently being rented out to another manufacturer for £80,000 per annum. The product will be charged £40,000 per annum for the space it utilises through the company's internal budgetary system. The fixed costs associated with the production are expected to be £250,000 per annum. Each product sold by the company is also allocated by the company's accountant an overhead charge of 5 per cent of the revenues it generates to cover head office expenses. The direct manufacturing costs are expected to be £7.00 per unit.
The company will need to hold stocks of the final product at the start of each year equivalent to 20 per cent of the sales expected in the next year and also stocks of materials and components equivalent to 20 per cent of the production expected in the next year. The materials and components account for £4.00 per unit out of the £7.00 overall direct cost per unit. The increase in debtors as a result of introducing the product will be offset by the increase in creditors. The company requires a rate of return of 12 per cent on investments of this nature, and the tax rate is 25 per cent.
a) Determine the investment's net present value, the internal rate of return, payback period and discounted payback period. All key assumptions should be specified and explained very carefully.
b) Interpret the NPV, IRR, payback period and discounted payback period, using the results of your evaluation of Newton's proposed investment to illustrate your answer.
Question 2: Valuation of a Company's Shares
Take the price earnings ratios for three companies traded on the London Stock Exchange from the data set given in the attached file. These companies are drawn from the FT 100, the hundred largest companies traded on the exchange, and the P/E ratios specified are for the end of each year from 2007 to 2013. The data also gives the P/E ratios for the index.
Discuss the factors that might explain the differences in the price earnings ratios of the three companies you have chosen and the changes that have occurred in their price earnings ratios over the six year period. (Choose companies with a range of P/E ratios to give you one with a relatively low value, one with a relatively high value, and another with a middling value.)
You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.
Whilst you need to gather some information on the companies you choose it is not anticipated that you undertake an in-depth analysis of the companies. It is acceptable to make use of some possible reasons to account for the differences in the price earnings ratios as well as employing the information that you gather on the companies.
Question 3: Rights Issue
Barclays announced on July30 2013 that the company would make a rights issue in September of the same year. The rights issue was planned to raise approximately £5.8 billion, with the shareholders being offered one new share at a subscription price of £1.85 for every four shares they were holding. The total number of shares to be issued was 3,216,893,546, equivalent to twenty five per cent of the shares outstanding at the time of the announcement. The share price immediately prior to the announcement was £3.095 and this fell to £2.93 when the issue was announced, a fall of 5.3 per cent. The announcement of a rights issue did not surprise the market, but the size of the issue was larger than anticipated. The issue was the 4th largest issue ever made by a bank. The issue was designed to help the bank meet a requirement that Barclays increased the ratio of its risk capital to its assets to 3 per cent and at the time Barclays had a shortfall of £12.8 billion in its risk capital given the value of its assets. Other measures were also announced at the same time to explain how Barclays intended to cover the deficit.
(Google "Barclays rights issue 2013" to gain access to the press coverage of the announcement.)
a) Explain and discuss the rationale provided for the rights issue. In answering the question take into account the financial performance and position of Barclays Bank at the time of the issue.
b) Specify the terms of the issue, the anticipated ex-rights price and calculate the value of a right. Utilise the price just prior to the announcement to undertake your calculations.
c) Demonstrate that an investor will in principle be equally well off from investing in the issue or selling the rights they have been allocated.
d) Identify and comment on the market's reaction to the announcement of the issue. Can the price pressure hypothesis account for the market's reaction or does the information hypothesis provide a better basis for interpreting the reaction?
The attached file (Stock returns 2007-13) gives 84 monthly returns for securities drawn from the FT ALL Share Index for the period January 2007 and December 2013.
a) i. The data set provided identifies four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx)) the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 84 months returns data in the calculations and use the Excel functions identified as Variance.P and Standard Deviation P.)
Next determine the monthly returns on the four portfolios along with the standard deviation of these returns. The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio.
Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of portfolio's returns. Comment on the difference between the outcomes.
Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification.
ii. Determine the variance of each security and the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Employ this information to calculate the standard deviation of the returns on the portfolio using the equally weighted portfolio risk equation.
b) Determine the betas for SSE (Scottish and Southern Energy), a utility company, and Barratt Developments, a construction company, by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spread-sheet).
i) Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies.
ii) Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companies
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Price-Earnings ratio is indeed one of the most important information and indication of the financial health of the company. This shows the degree and extent to which the investors have trust over the company and the aggressiveness of the investors to invest in this company. Hence a higher price-earnings ratio is always an indication of the fact that the investors do prefer the company much more than what they do for the other companies. Hence it is always suggested that there must be proper financial analysis and proper understanding of the key forms of the business along with the P/E ratio to know the actual situation. There are various reasons why this P/E Ratio changes over time period. The most important ones amongst the same is information available with the shareholders regarding the company and their level of expectations from the company, because of which they believe that they will have to introduce some of the key changes in the company. Along with the same, the increase in competition and the investor preference over one stock to the other, the internal management concerns and other similar facts which may lead to major changes over the prices of the stocks are the reasons for this change.