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N11605-E1
The University of Nottingham
BUSINESS SCHOOL
A LEVEL A MODULE, SPRING SEMESTER 2010-2011
BUSINESS FINANCE (N11605)
Time allowed TWO Hours
Candidates must NOT start writing their answers until told to do so
Section A consists of 25 Multiple Choice Questions (MCQ).
Use the special answer sheet provided to mark your answer. 2 marks are given for each correct answer. No marks and no penalty are given for an incorrect answer or failing to answer a particular question.
Answer TWO Questions in Section B.
Questions in Section B are worth 25 marks each.
Only silent, self contained calculators with a Single-Line Display or Dual-Line Display are permitted in this examination.
Dictionaries are not allowed with one exception. Those whose first language is not English may use a standard translation dictionary to translate between that language and English provided that neither language is the subject of this examination. Subject specific translation dictionaries are not permitted.
No electronic devices capable of storing and retrieving text, including electronic dictionaries, may be used.
DO NOT turn examination paper over until instructed to do so
ADDITIONAL MATERIAL:Special answer sheet for Section A
Present value tables
Annuity tables
Formula sheet
SECTION A
Multiple Choice Not available
SECTION B
Answer any TWO questions from this section.
26.(a)When evaluating annual cash flows as part of a project’s NPV calculation there are two different ways to handle inflation predictions.
Describe these two ways explaining the principles behind them and highlighting the differences in their application in practice.
(30%)
(b)A four year project is being investigated. The details are:
Purchase of equipment:£800,000
Sale of equipment (end of year 4):£200,000
Capital allowance on equipment (reducing balance):20% p.a.
Annual working capital requirement:£50,000
Rent of premises per year:£75,000
Net (not including rent) annual operating income:£350,000
All of the above cash-flow and cost estimates are in real terms and may be assumed to be correct over the whole of the first year of operation.
Inflation is expected to be 5% per year and affects all appropriate annual costs and income other than the rent on the premises.
The rent has been negotiated to remain at a fixed amount over the four year period but must be paid at the start of each year.
It may be assumed that any negative tax cash-flows are allowed as they act as a reduction in tax paid by the firm on other income it receives.
(i)Produce a table of inflation adjusted cash flows (i.e. show the nominal amounts). Each of the above must be shown explicitly.
(40%)
(ii)If the discount rate to be used is 10% in real terms and the corporate tax rate is 28% p.a. produce an NPV for the project.
(15%)
(iii)Should the project be pursued? Explain the NPV rule and why this is an appropriate decision making tool.
(15%)
27.(a)When performing a project appraisal one way of handling the risk in future values is to use expected present values and decision trees.
Explain this method and give a (very) simple example of how the NPV of a project with a decision is handled.
(30%)
(b)A project is started and it is thought that for the first two years the end of year net cash-flows will be £1,000,000. After two years there is considerable uncertainty and three scenarios for the future are considered; Good (G), Average (A) and Bad (B). It is estimated that these scenarios will occur with probabilities pG=0.25, pA=0.5 and pB=0.25. The NPV of all future cash flows from after year 2 onwards has been calculated for each scenario and these are thought to be £5,000,000, £3,000,000 and £1,000,000 in the three scenarios respectively. This is summarised in the following table:
Year 1 / Year 2 / Start of year 3 onwardsCash-flow / Cash-flow / NPV of all future cash-flows / Probability
£1m / £1m / £5m (Good) / 0.25
£3m (Average) / 0.50
£1m (Bad) / 0.25
The initial cost of the project is £4,000,000. The appropriate discount rate is 15%.
(i)What is the expected NPV of this project?
(20%)
(ii)Suppose that at the start of year 3 the scenario that will occur is known and that the project can, if desired, be abandoned selling all of the facilities and receiving £3,000,000. What is the expected NPV in this case?
(30%)
(iii)What is the value of the flexibility to abandon the project as outlined in the previous part?
(20%)
28.(a)Define the following financial securities and their features:
- Ordinary shares (features: dividends, nominal or face value, market value).
- Preference shares (features: dividends, nominal or face value, market value).
- Bonds (features: coupons, nominal or face value, redemption, market value).
- Convertible bond.
(40%)
(b)What is meant by the cost of capital of a security to the issuing company and how does this differ from the expected rate of return for an investor?
(10%)
(c)A firm has issued debt with a face value of £100 million. The debt is in the form of bonds each with a face value of £10,000 and a current market value of £10500. The bonds issue coupons of £500 every 6 months and have 50 years remaining to maturity.
The same firm has 50,000,000 shares issued which have a current market price of £3.50 each and a face value of 20p each. A dividend has just been issued of 30p per share. Dividends are expected to grow at 8% per year.
The corporate tax rate is 28%.
Calculate the cost of capital of the debt and the equity and calculate the discount rate that should be used for project valuations.
(Hint:Since the bonds have such a long life you may assume they never terminate.)
(50%)
N11605-E1TURN OVER
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N11605-E1
29.(a)Discuss the CAPM, the expected company returns that it predicts and how it can be possible for a company with very high risk to provide lower returns than a company with a lower risk while both still satisfy the CAPM framework.
(30%)
(b)You have £1,000,000 and decide to invest in stocks. There are two stocks that interest you belonging to SuperRisk plc and ReallySafe plc. Writing the expected annual returns and volatilities on these stocks asand you are given the following data:
(Reminder: The volatility is the square root of the variance of the returns.)
You are also told that the stock returns have a correlation, , given by .
(i)If you invest 35% of your wealth in SuperRiskplc and the rest in ReallySafeplc then what is the expected return and volatility of your portfolio?
(25%)
(ii)Compare the volatility (i.e. risk) of the portfolio above with those of the individual stocks. Explain why the risk has behaved in the way it has?
(20%)
(iii)Now you borrow £500,000 of risk free funding at 5% p.a. and invest all of this in ReallySafe plc. This is in addition to the earlier investments you made. Your portfolio will now consist of the total investment in stocks and your borrowing. What is the expected return and volatility of your portfolio now?
(25%)
N11605-E1END