Reference no: EM13793328

Question 1:

a) An investment of £45,000 is expected to produce a constant net cash flow of £13,100 per annum for each of the next five years and the required rate of return is 12 per cent. Determine the investment's internal rate of return, net present value and the payback period. Provide a brief interpretation of your results.

b) Penlan Ltd. has been negotiating terms for a loan from a bank. A loan of £400,000 has been agreed with interest rate of 12 per cent per annum to be paid on the outstanding balance of the loan. If the loan is to be repaid in six equal annual instalments determine the value of the instalments.

c) A company's pension fund advisors have estimated that ten years from now the fund will have a deficit of £4.2 million. The company has decided to increase its contributions over the next ten years to cover this deficit. It plans to increase its annual contributions to the pension fund by a constant annual amount. By how much will it have to increase its annual contributions to meet its obligations, if it is anticipated that the pension fund's assets can earn 6 per cent per annum?

d) Explain how the impact of inflation on the expected net cash flows and the required rate of return can be incorporated into an investment appraisal.

Question 2:

a) Explain what is meant by the net present value of an investment and discuss how the use of the NPV as an investment decision rule is related to the objectives of the company.

b) Discuss the advantages and disadvantages of the use of the internal rate of return as an investment criterion.

Question 3:

The research and development group of Dremen Ltd are finalising work on their latest new product. The expenditure so far on this product is £250,000 and it is anticipated that a further £50,000 still needs to be spent on the formal testing for regulatory purposes. As a result of formal testing it is not anticipated that any problems will be encountered in the testing. The company has to decide now whether to invest in production facilities for the product.

An assessment of the potential market suggests that the company should be able to sell 30,000 units in the first year at a price of £60 per unit. Sales in the second year are expected to be 20 per cent higher than in the first year and sales are expected to remain at this level from year two to year five. The introduction of the product will require a one off marketing expenditure of £70,000. Technological change in the area is rapid and it is anticipated that the product will be withdrawn after five years. The direct cost per unit has been estimated at £30. The production will also lead to £130,000 of fixed costs.

The additional production equipment required will cost £1,600,000 and it will qualify for straight-line depreciation over eight years for tax purposes. As the product life is relatively short the equipment is expected to have a resale value of £150,000 after five years use. Use will also be made of some assets already owned by the company. These assets have been fully depreciated for tax purposes but could be sold for £90,000. If used in the production the new product their value is expected to fall to £50,000 by the end of five years.

The productions will be located in one of the company's existing buildings. The company owns the building and will incur no cash outflow for its use in this project. However, the company is currently renting out this space for £22,000 per annum, but the rental agreement allows the arrangement to be terminated at one months notice.

The company will hold 20 per cent of next year's sales in the form of stocks. The net impact of proceeding with the investment on creditors and debtors will be zero.

a) If the required rate of return is 14 per cent determine the investment's NPV, stating the key assumptions employed in the analysis. The tax rate is 30 per cent.

b) Discuss briefly the basis for treating the following items in investment appraisal

i. Working capital.
ii. Equipment owned by the company that would be employed in the project.
iii. Sunk costs.

c) Undertake an analysis of the sensitivity of the NPV to the assumed price of the product and briefly discuss the results of the analysis.
 
Question 4

a) Braehead plc has grown steadily in recent years. Its expected earnings per share next year is £0.75 while the dividend per share next year is £0.60 and dividends are expected to grow at 5 per cent per annum indefinitely into the future. Employing the constant rate of growth of dividend model determine the price of the share given a required rate of return is 15 per cent, assess the contribution of growth to the value of the share, and calculate the rate of return anticipated on the investment financed by retentions.

b) Mark Engel is a security analyst and one of the companies he is responsible for monitoring is Pembrey plc. His analysis of the company suggests that it will pay out dividends of £4.00, £5.00 and £6.00 in years one to three. From three onwards dividends are expected to grow at 4 per cent per annum indefinitely into the future. If the required rate of return is 12 per cent determine a value for the company's shares.

d) Explain and comment on the insights providedby valuation models for the determinants of price earnings ratios.

Question 5

a) Explain what is meant by a rights issue and comment on the role of rights issues in protecting the interests of shareholders.

b) Hendy plc has grown rapidly over the last few years and has funded its growth by borrowing heavily. It has achieved a high rate of return on capital employed and with a high level of gearing has produced even higher returns for its shareholders. It is anticipated that the company will need to raise more funds externally over the next few years to finance its capital expenditure. The board of directors have recognised that the company cannot increase its debt-equity ratio further. It has been decided to reduce its debt-equity ratio, so as to provide the possibility of further borrowing in subsequent years. On this basis the board of directors has decided to undertake a rights issue to raise £480 million. The company's shares are trading at £1.50 and it is proposed to make the rights issue at a discount of 20 per cent to the current price. The company's investment bank sees no problems in raising the funds required but it has been decided to have the issue underwritten. The company has 800 million shares outstanding giving its equity a market value of £1200 million.

Determine the terms of the issue, the expected ex-rights price of a share, and the value of a right.

c) Demonstrate that in principle a shareholder, holding 300 shares, will be equally well off from investing in the new shares or selling his or her rights.

d) Explain what is meant by the price pressure hypothesis and comment on its ability to explain the tendency for the price of shares of a company announcing a rights issue to fall.

Question 6

a) Explain how diversification can reduce risk exposure and discuss the limits on risk reduction likely to be encountered in practice.

b) Determine the expected return and risk of an equally weighted portfolios

i. The choice is limited to two securities, security A with an expected return of 14 per cent with a standard deviation of 20 per cent, security B with an expected return of 19 per cent and a standard deviation of 26 per cent, and the covariance of the returns on these two securities is 180.

ii. A portfolio of 50 securities, given an average expected return on the securities of 13 per cent, an average variance of returns of 256, and an average covariance of 102.4.

c) Explain what is meant by the beta of a security and discuss its determinants.

Question 7

Graham plc is planning to raise funds to finance a major investment, and its management is considering borrowing on a long term basis for the first time. It has been established that it is possible to borrow £160 million at an interest rate of 8 per cent to meet its funding requirements. Alternatively it could issue 80 million shares at the prevailing market price of £2.00 through a private placement. The market has been kept informed of the company's investment plans and it is anticipated that such an issue will leave the share price unchanged. The company currently has 240 million shares outstanding. The company's expected earnings before interest and tax for next year, after taking the expansion of the company's assets into account, has been estimated to be £120 million.

a) Assuming a corporate tax rate of 40 per cent determine the expected earnings per share of the company under the both forms of financing.

b) Explain why the use of debt can be expected produce an increase in the expected rate of return on equity capital and the expected earnings per share if the rate of return on assets is higher than the interest rate.

c) Discuss whether or not an increase in the expected rate of return on equity and the expected earnings per share will necessarily lead to an increase in the share price and shareholder value.

d) Explain what is meant by the weighted average cost of capital. Can this be expected to fall with as a result of substituting cheap debt for expensive equity?