UNIVERSITY OF SOUTHAMPTON ECON6044W1 SEMESTER 2 EXAMINATIONS 2018-19 ECON6044 Principles of Corporate Finance Duration: 120 MINS (2 HRS) This paper contains 6 questions Answer any 5 questions. Each question carries 1/5 of the total marks for the exam paper and you should aim to spend about 22 minutes on it. An outline marking scheme is shown in brackets to the right of each question. Only University approved calculators may be used. A foreign language direct ‘Word to Word’ translation dictionary (paper version) ONLY is permitted. Provided it contains no notes, additions or annotations. Copyright 2019 v01 c© University of Southampton Page 1 of 5 2 ECON6044W1 1 (a) An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9%, what is the NPV? [6] (b) Mike Polanski is 30 years of age and his salary next year will be $40,000. Mike forecasts that his salary will increase at a steady rate of 5% per annum until his retirement at age 60. b1) If the discount rate is 8%, what is the PV of these future salary payments? b2) If Mike saves 5% of his salary each year and invests these savings at an interest rate of 8%, how much will he have saved by age 60? b3) If Mike plans to spend these savings in even amounts over the subsequent 20 years, how much can he spend each year? [7] (c) Here are two useful rules of thumb. The Rule of 72 says that with discrete compounding the time it takes for an investment to double in value is roughly 72/interest rate (in percent). The Rule of 69 says that with continuous compounding the time that it takes to double is exactly 69.3/interest rate (in percent). c1) If the annually compounded interest rate is 12%, use the Rule of 72 to calculate roughly how long it takes before your money doubles. Now work it out exactly. c2) Can you prove the Rule of 69? [7] 2 A company has been considering the production of a new product and has two different methods of production, Option A and Option B. The costs and returns associated with Option A are displayed in the table below and are based on expected unit sales of 100,000 (all figures are in $ billions). Assume that the cost of capital is 10% and that income is taxed at a rate of 50%. Ignore depreciation. Option B would require an extra investment of $11 billion more than Option A but would reduce variable costs by $100,000 per unit compared to those of Option A. Copyright 2019 v01 c© University of Southampton Page 2 of 5 3 ECON6044W1 Year 0 Years 1-5 Investment $15 Revenue $37.5 Variable Cost $30 Fixed Cost $3 Pretax Profit $4.5 Tax $2.25 Net Operating Profit $2.25 (a) Suppose a manager has already estimated a project‘s cash flows, calculated its net present value (NPV), and done a sensitivity analysis. List the additional steps required to carry out a Monte Carlo simulation of project cash flows. [6] (b) What is the NPV of Option B? [8] (c) Draw a break-even chart for Option B based upon projections of sales and explain how you would interpret the break-even figure. [6] 3 (a) Define the following: (a1) Agency costs (a2) Entrenching investment (a3) Empire building [6] (b) Suppose all plant and division managers in a firm were paid only a fixed salary with no other incentives or bonuses. Describe the agency problems that would appear in capital investment deci- sions. How would tying the managers‘ compensation to eco- nomic value added (EVA) alleviate these problems? [7] (c) The table below shows a condensed income statement and bal- ance sheet for a plant. Calculate the plant‘s EVA. Assume the cost of capital is 9%. [4] Copyright 2019 v01 c© University of Southampton TURN OVER Page 3 of 5 4 ECON6044W1 Income Statement Assets at 31.12.2018 Revenue 56.66 Net working capital 7.08 Raw materials cost 18.72 Operating cost 21.09 Investm’t plant & equip’t 69.33 Depreciation 4.50 Less acc. depreciation 21.01 Pretax income 12.35 Net plant & equipment 48.32 Tax at 35% 4.32 Net income 8.03 Total assets 55.40 (d) As the table in part (c) shows, the plant is carried on the books at $48.32 million. However, it could be sold to another copper company for $95 million. How should this fact change your calculation of EVA? [3] 4 (a) Explain the three forms of market efficiency. [6] (b) Give two examples of research results or events that raise doubts about market efficiency. Briefly explain why. [6] (c) Here are alphas and betas for Company X and Company Y for the 60 months ending April 2019. Alpha is expressed as a percent per month. A month later, the market is up by 5%, X is up by 6% and Y is up by 3%. What is the abnormal rate of return for X and Y? [4] Alpha Beta X 0.57 1.08 Y 0.46 0.65 (d) What does the efficient-market hypothesis imply about the role of a financial manager in charge of portfolio selection? [4] 5 In 2001 the Pandora Box Company made a rights issue at £5 a share to its current shareholders offering one new share for every four shares already held. Before the issue there were 10 million shares outstanding and the share price was £6. Copyright 2019 v01 c© University of Southampton Page 4 of 5 5 ECON6044W1 (a) What was the total amount of new money raised? [4] (b) What was the value of the right to buy one new share? [4] (c) What was the prospective stock price after the issue? [4] (d) How far could the total value of the company fall before share- holders would be unwilling to take up their rights? [4] (e) Explain the difference between a uniform-price auction and a discriminatory auction. Why might you prefer to sell securities by one method rather than another? [4] 6 Hors dAge Cheeseworks has been paying a regular cash dividend of $4 per share each year for over a decade. The company is paying out all its earnings as dividends and is not expected to grow. There are 100,000 shares outstanding selling for $80 per share. The com- pany has sufficient cash on hand to pay the next annual dividend. Suppose that Hors dAge decides to cut its cash dividend to zero and announces that it will repurchase shares instead. (a) What is the immediate stock price reaction? Ignore taxes, and assume that the repurchase program conveys no information about operating profitability or business risk. [5] (b) How many shares will Hors dAge purchase? [5] (c) Project and compare future stock prices for the old and new policies. Do this for years 1, 2, and 3. [5] (d) Managers and investors seem more concerned with dividend changes than with dividend levels. Why is this the case? [5] END OF PAPER Copyright 2019 v01 c© University of Southampton Page 5 of 5 Social Sciences Examination Feedback 2018/2019 Module Code & Title: ECON6044 Principles of Corporate Finance Module Coordinator: Jana Sadeh Mean Exam Score: 57.38 Percentage distribution across class marks: UG Modules 1 st (70% +) 2.1 (60-69%) 2.2 (50-59%) 3rd (40-49%) Fail (25-39%) Uncompensatable Fail (<25%) PGT Modules 70% + 15.5% 60-69% 31.0% 50-59% 36.2% <50% 17.2% Overall strengths of candidates’ answers: There was a mixed outcome from candidates, with some clearly showing evidence of having understood the material while others were less sure. The main strengths were in the problem based questions and in the questions that covered material that was similar to material covered in the coursework. Overall weaknesses of candidates’ answers: There was a clear weakness in written explanations and short essay style questions. Pattern of question choice: The exam required them to pick any 5 questions out of 6. The number of candidates who selected each question are as follows: Q1-57, Q2-35, Q3-47, Q4-53, Q5-56, and Q6-43. This makes Q1 the most popular question, while Q2 was the least. Overall there was no particular question that was clearly identified as the hardest and not selected. Issues that arose with particular questions: The most popular question (Q1) was not one where the students performed very well. Part c especially was not attempted by many students, even though the working was very straightforward. In Q2a some students clearly did not understand what the question asked of them, and this is a general weakness of this cohort, understanding the more descriptive questions. Q3 and Q4 had no particular issues. Q5 and Q6 are two questions where students performed very well. Further comments not covered above: None Discipline vetting completed By (Name): Date:
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