Paper Code: ACFI304 Page 1 of 20 Paper Code: Department: ULMS Examiner: Tel. No: 50573 JANUARY EXAMINATIONS 2019 ACFI304 Business Finance TIME ALLOWED: Two Hours INSTRUCTIONS TO CANDIDATES The use of pre-programmable calculators is not permitted during this exam. NAME OF STUDENT STUDENT ID NUMBER USUAL SIGNATURE Answer at least one question from Section I Answer at least one question from Section II Answer one more question from either Section I or Section II Answer three questions in total All questions carry equal marks Note: Formula sheet, distributions and financial time value tables are attached. Paper Code: «Module» Page 2 of 20 JANUARY EXAMINATIONS 2019 ACFI304 Business Finance Section I Instruction: answer at least one question from this section. Question 1 a) Many mergers which make economic sense, fail. Suggest and explain plausible reasons for their ultimate failure. (12 marks) Suggested Answer: • Differences in production processes – which ones continue, which ones are mothballed, how are existing ones integrated? • Differences in accounting / finance methods eg expense claims and bonus / share option schemes. • Disagreement over who stays / goes – if your most innovative / creative staff want to leave as a result of the merger, it defeats the object of trying to keep the expertise within the organisation. There may be disagreements over who keeps their jobs in general, which board members remain and who has the power going forward? • Differences in pay / benefits and salary structures. • Differences in knowledge / credentials / training provisions. • Cultural issues – the two organisations can’t agree on practices and procedures and how business is done day to day (eg. Daimler-Benz vs Chrysler – both culturally very different, DB eventually offloading 80% of its stake in Chrysler). • Legal issues – breaching of anti-trust laws in the US – failure occurs because competition within the industry would subsequently be reduced – within the UK and Europe you have the EU Commission and the Competition Commission. • Public anti-sentiment forcing the Government to intervene. • Protecting certain “sensitive” sectors from foreign ownership eg. Defence. Approx. 1.5 marks per suggestion but other viable suggestions may be considered. b) Calculate the price of a call option by using the Black-Scholes option pricing model, given the following information: Stock price = £75, strike price = £90, Time to Expiration = 4 weeks, stock price variance = 0.40, risk-free interest rate = 0.05. (13 marks) Paper Code: «Module» Page 3 of 20 Suggested Answer: The call option price is found by the formula: C = S x N(d1) – Xe-rt x N(d2) Where, d1 = [ln(S/X) +(r + 1/22)t]/[ t] d2 = d1 - t; N = Cumulative Normal Distribution d1 = [ln(£75 / £90) + (0.05 + (0.40 / 2)) (4 / 52)] / [0.40 (4 / 52)]0.5 = -0.9298 d2 = -0.9298 - [0.40 (4 / 52)]0.5 = -1.11 to 2 dps N(d1) = N(-0.92) – 0.98*[N(-0.92) – N(-0.93)] = 0.1788 – 0.98*(0.1788 – 0.1762) = 0.176252 N(d2) = N(-1.11) = 0.1335 C = [£75 N(d1)] - [£90 e-(0.05)(4/52) N(d2)] = [£75 (0.176252)] - [£90 e-(0.05)(4/52) (0.1335)] = £13.2189 - £11.9688767 = £1.25 c) Describe forward rate agreements using an appropriate numerical example in your answer. (8 marks) Suggested Answer: The applicable money market rates are: » 2 months 5.25% - 5.75% » 6 months 5.5% - 6% » 8 months 5.625% - 6.125% – Scenario: The firm’s cash flow forecast shows that £50m is required in two months time to fund operations for the following six months - the firm will borrow £50m in 2 months time at whatever the 6-month rate is in 2 months’ time Paper Code: «Module» Page 4 of 20 – The current six-month money market interest rates are 5.5% - 6% – The Treasurer believes interest rates are expected to rise over the following two months, implying exposure to interest rate risk due to the expected higher borrowing costs in 2 months-time (ie. at which time, the firm will need to borrow £50m) – In a separate transaction, today, the firm can approach a financial institution through the money markets to fix today the interest rate that it has to pay in two months’ time on a notional value of £50m for 6-months (hedging via a FRA) – The FRA is thereby a separate mechanism through which a company can lock itself into a rate of interest today, for a future loan. – The forward 6-month rate that the financial institution proposes on the FRA is likely to be 6.4167% since they determine such rates by taking into account forward forward loans (borrowing for 8 months today at 8 month rate, place on deposit for 2 months at 2 month rate – net interest derives the fwd 6-month rate) – If the actual 6-month interest rate rises to 8% in 2 months, the company receives 1.5833% compensation under its FRA to bring its net interest cost back to 6.4167% (paying 8% on its separate transaction of the £50m 6-month loan but receiving 1.5833% from the FRA) – If the actual 6-month interest rate falls to 5% in 2 months, the company pays 1.4167% compensation to the F.I to keep an annual interest rate at 6.4167% (paying 5% on its separate loan but also paying 1.4167% on the FRA). – The latter scenario ends up costing the firm more than if they had just taken the risk of being unhedged! – Note that the FRA is a totally separate contractual agreement from the loan itself. [Total: 33 marks] Paper Code: «Module» Page 5 of 20 f Question 2 a) Explain what happens to the price of a European Call Option when each of the five variables in the Black-Scholes options valuation model changes. You are to assume that only one variable changes at any given time and the remaining variables remain constant. (12 marks) Suggested Answer: • It essentially revolves around the likelihood of an option being in the money when it matures. • For a call, if the stock price is increasing, moving further away from the strike (currently ITM) or towards the strike (if currently OTM), the option price increases because it is more likely to end up in the money. St must be > strike for option to be ITM. • If stock price reduces, moving towards the strike (currently ITM), call option price decreases as there is a greater chance that it will end up out of the money. Likewise, if it is currently OTM, and the price moves further below the strike, very likely to finish OTM. • An increase in volatility means that the stock price is moving a lot around the expected value. Thereby, there is an increased probability of extreme changes both up and down (deemed increased chance of moving from out of the money to into the money) • For both calls and puts , the greater the time to maturity, the more time there is for an option to move from out of the money to into the money. • Time value of money factor: refers to the discounting applied by the risk free rate of return. For a call, its price is equal to • C = N(d1)*S – X e-r TN(d2) • Here, you are subtracting the present value of the exercise price. • So, increased rf means that the PV of the strike is smaller and you are subtracting a smaller value from the N(d1)*S. • As rf increases, PV is smaller, option price is larger • When rf is 12% as opposed to 10%, for example, X e-rfTN(d2) becomes smaller and you are therefore subtracting a smaller number from N(d1)*S, and the resultant call price is larger. Paper Code: «Module» Page 6 of 20 b) In relation to a firm’s dividend policy, compare and contrast the “Bird in Hand Theory” and the “Clientele Effect.” (13 marks) • The former theory advocates that increasing dividends increases a firm’s value. Shareholders are risk-averse and prefer to receive dividend payments rather than capital gains in the future. • ie: “A bird-in-the hand is worth more than two in the bush”. • There will be increased demand for the common stocks of companies that pay generous dividends compared to companies that pay smaller dividends • Pushes stock price up of those companies paying more generous dividends – Firms incentivised to pay more generous dividends for the subsequent increase in value With regards the Clientele Effect, it offers a contrary argument to the Bird in Hand – different investors will be attracted to the firm whose dividend payout policy suits them and therefore, the policy will not affect a firm’s value. • Corporations differ with respect to their dividend policy: • High dividend pay-out ratio. • Low dividend pay-out ratio. • Investors also vary with respect to their preferences • Some prefer high dividends. • Others prefer low dividends. • In conjunction with Modigliani and Miller (1961): There are enough firms out there to suit the dividend preferences of all investor types: “as there are enough shares to satisfy the needs of particular investor clientele, no corporation will be able to affect its share price by changing its dividend policy.” • Those who prefer low pay-out won’t switch to and be attracted by the higher pay out firms • Dividend policy does NOT affect a firm’s value! Ultimately, each corporation tends to attract a clientele consisting of those investors who prefer its particular pay-out ratio. Paper Code: «Module» Page 7 of 20 c) Storm Plc starts life with all equity financing and a corresponding cost of equity of 14%. Suppose that it refinances to the following market value capital structure: Debt: 45% Equity: 55% Cost of Debt: 9.5% Use Modigliani and Miller’s second proposition (MM II) to calculate the new cost of equity resulting from the new capital structure. Then calculate Storm Plc’s after-tax WACC if the marginal rate of tax is 40%. (8 marks) Suggested Answer: According to MM II, WACC does not change when capital structure changes so calculate the WACC prior to the capital structure change: WACC is therefore just the cost of equity of 14% because it is 100% equity financed! New cost of equity with WACC unchanged: 45 = 14% + (14% − 9.5%) × 55 = 17.68% Storm’s after tax WACC: We have to adjust the Cost of Debt by the marginal rate of tax: = (9.5% × (1 − 0.40) × 45 ) + (17.68% × 55 ) = 12.289% 100 100 Paper Code: «Module» Page 8 of 20 [Total: 33 marks] Question 3 a) When considering the motivations of a firm wanting to merge its business with another firm, explain the meaning of “Economies of Scale” and “Economies of Vertical Integration.” (8 marks) Suggested Answer: Economies of Scale A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units. Economies of such merger may come from sharing central services such as office management and accounting, financial control, executive development, and to-level management Economies of Vertical Integration Control over the production process by expanding back toward the output of the raw material and forward to the ultimate consumer Merge with a supplier or a customer Control over suppliers “may” reduce costs. Over integration can cause the opposite effect. b) The chart below plots the monthly returns of the stock FinCo Plc versus the monthly returns of the underlying market index, the Ftse-All-Share. The data is for the period November 2009 to November 2014. Paper Code: «Module» Page 9 of 20 Required: i) What proportion of FinCo Plc’s returns could be explained by market movements? Explain your answer. ii) What proportion of risk could be said to be diversifiable? iii) How does the diversifiable risk show up on the plot? Explain your answer. (4 marks) (2 marks) (4 marks) iv) What is the 95% confidence interval for the range of possible beta estimates? (4 marks) Total: (14 marks) Suggested Answer: i) The R-squared value represents the proportion of the total variance in the stock’s returns that can be explained by the movements in the market. It is the goodness of the fit of the FinCo return, % Paper Code: «Module» Page 10 of 20 model to the data and has a value of 60% in this case. Ie 60% of the variance in FinCo Plc’s returns could be explained by the variance in the market’s returns in this case for this data set. ii) If 60% of the variance in FinCo’s returns is explained by the market (systematic element and non-diversifiable), then 40% remains to be explained. The latter is attributable to the diversifiable risk components of FinCo Plc. iii) The line of best fit represents the modelling of the impact of the market on the stock’s returns (based on the data gathered). How scattered the plot is around the line of best fit indicates the strength of the model – more scatter and more outliers away from the line indicates less accuracy in the model. Therefore, the diversifiable / non-market influence is represented by the extent of the scatter of the data around the line of best fit. This is further evidenced by the size of the R-squared value. iv) •95% CI = Estimated Beta +/- (1.96 * standard error) CI = 1.65 +/- (1.96*0.17) 1.65 +/- (0.3332) Therefore, the true beta for FinCo is between 1.9832 and 1.3168 and we have a 95% chance of being correct. The range of possible errors in the Beta estimate is +/- 0.3332. c) Describe the characteristics of a finance lease and from the perspective of the lessee, explain why companies engage in leasing in general. (11 marks) Suggested Answer: – Financial Lease: long term, extending over most of the economic life of the asset – Cannot be cancelled by the lessee – The lessee must also agree to maintain the asset and insure it – The asset becomes the property of the lessee at the end of the lease if all of the payments plus interest have been made – OR, it becomes the property of the lessee upon payment of a final “balloon” amount – Leasing preserves capital: Reduces borrowing to purchase the asset; though it is possible to borrow the face value of the asset holding it as collateral if the asset is Paper Code: «Module» Page 11 of 20 initially bought for cash. Hence, the bank balance will remain the same by leasing or buying and borrowing! Leases may be off balance sheet financing: For example, in Germany, an asset acquired and financed through assets acting as collateral as well as the lease are excluded from the balance sheet. [Total: 33 marks] Section II Instructions: answer at least one question from this section. Question 4 a) In relation to theories explaining the shape of a yield curve, discuss the liquidity preference theory. (8 marks) Suggested answer: • In the real world, investors do not know with certainty the future course of interest rates. • Holding a short-term bond means that the investor will be subject to less uncertainty than a holder of long-term bonds. • According to the liquidity preference theory, bondholders are generally risk averse in that they will wish to be compensated for the higher risk involved in holding long-term bonds by an appropriate risk premium on those bonds. • the yield on longer-term bonds will therefore reflect not only market expectations (as outlined in the expectations theory), but also a liquidity premium. • The liquidity preference theory therefore predicts a generally higher set of interest rates than the expectations theory. • The basic idea is that lenders of funds prefer to lend short, while borrowers generally prefer to borrow long. Hence, borrowers are prepared to pay a liquidity premium to lenders to persuade them to lend long. The size of the liquidity premium increases with the time to maturity. b) The manager of ABC Corp. wants to evaluate a potential investment project that will be financed with debt and equity in a ratio of 0.70:1. He sources a comparable company with an equity beta of 1.30 and a debt to equity ratio of 0.40. The tax rate for both the project and the comparable company is 35%. Paper Code: «Module» Page 12 of 20 Required: i) Calculate the unlevered beta for the comparable company; ii) Calculate the levered beta for the project; (3 marks) (3 marks) iii) Explain why ABC Corp cannot simply use its own cost of capital to evaluate the project. (8 marks) Total: (14 marks) Suggested Answer: Apply the following formulae: 1 , = 1.30 × [ ( ] = 1.032 1 + (1 − 0.35) × 0.40) , = 1.032 × [1 + ((1 − 0.35) × 0.70)] = 1.502 The company’s cost of capital can be regarded as the opportunity cost of capital for investing in all of the firm’s assets and thereby the appropriate discount rate for the firm’s projects of similar or average risk (& subsequently those potential projects under review if they are of the same / similar risk). The firm’s cost of capital would not be appropriate if the project under consideration was more or less risky than the firm’s existing business. The E(R) / required rate of return and potential added value that the project could create for the investing firm should be higher (lower) to reflect higher (lower) levels of risk. If we just accepted or rejected projects / investment opportunities merely on the basis of the investing company’s Cost of Capital then: Many low risk projects would be rejected (the expected / required rate of return is set too high). Many poor, high-risk projects would be accepted (the expected / required rate of return is not high enough here to reflect the greater risk). c) Explain how the Treynor’s Ratio is interpreted in evaluating the performance of a portfolio and how it differs from the Sharpe Ratio. (11 marks) Paper Code: «Module» Page 13 of 20 [Total: 33 marks] Suggested Answer: Treynor’s: = − Treynor’s measure gives us a measure of return per unit of market risk (or systematic risk) that our investment earns. The larger the Treynor measure, the better. However, we would like to have some benchmark with which to compare our individual Treynor measures. –If TP > Tm, the portfolio would plot above the security market line, indicating superior performance by the portfolio manager. –If TP < Tm, the portfolio would plot below the security market line, indicating poor performance by the portfolio manager. Suitable for diversified portfolios. For a completely diversified portfolio of assets, the Sharpe and Treynor measures would be identical in what they are measuring. Treynor measures performance relative to systematic risk. Sharpe measures performance relative to total risk. Sharpe measure gives some indication of how good the portfolio manager is at diversifying away unsystematic risk. Question 5 a) Discuss the Capital Asset Pricing Model, including its assumptions and limitations. (15 marks) Suggested answer: () = + ( − ) • Its major conclusion is that expected returns on an equity stock are related to its systematic and not to its total risk or standard deviation. • A stock’s beta is a measure of its co-movement with the market index. • The CAPM follows from the Tobin extension to the Markowitz model but requires additional assumptions. Assumptions: Paper Code: «Module» Page 14 of 20 1. All investors are assumed to follow the mean-variance approach. 2. Assets are infinitely divisible. 3. There is a risk-free rate at which an investor may lend or borrow. 4. Taxes & transactions costs are irrelevant. 5. All investors have same holding period and Risk-free rate 6. Information is freely and instantly available to all investors. 7. Investors have homogeneous expectations. 8. Markets are assumed to be perfectly competitive. Limitations: The model makes unrealistic assumptions Model parameters cannot be estimated precisely • Definition of a market index • Firms may have changed during the 'estimation' period • Econometric Problems The model does not work well • If the model is right, there should be ➢ a linear relationship between returns and betas ➢ the only variable that should explain returns is betas • The reality is that (see Fama and French, 1991) ➢ the relationship between betas and returns is weak ➢ other variables (size, price/book value) seem to explain differences in returns better. b) Define the meaning of efficient markets and the weak form concept of market efficiency. (8 marks) Suggested answer: • A market in which security prices adjust rapidly to the arrival of new information • The current market price reflects all available information about the security • We have an “informationally efficient” market • The sub-hypotheses of efficiency, reflect the different information sets • It is possible to generate abnormal risk adjusted returns (ie. An excess return above the expected return) but you cannot achieve this on a consistent basis net of transaction cost. • Weak-Form EMH Paper Code: «Module» Page 15 of 20 Current prices reflect all security-market historical information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information (eg. block trading) This implies that past rates of return and other market data should have no relationship with future rates of return, as current prices already reflect such past information (past ROR independent of future ROR) Implication: Trading rules / strategies developed from the analysis of historical price or returns data derives little benefit. c) When considering the relationship between a bond’s price and yield to maturity, explain each of the following characteristics: i) the inverse relationship between price and yield to maturity; ii) the convexity effect; iii) the coupon effect; iv) the maturity effect. (10 marks) Suggested answer: When YTM increases, the bond price decreases and vice-versa. The cash flows are fixed but the discounting factor is either decreasing when YTM decreases (leading to increased PV) or increasing when YTM increases (leading to decreased PV). The relationship between bond prices and YTM is not a linear one. If you were to graph YTM on the x-axis and bond price on the y-axis, as you reduce the YTM, the change in the price is not linear and the graph is not a straight line. It is actually a curve with the gradient at any point on that curve increasing as we move from right to left along the x-axis. Comparing two bonds with the same maturity, same par value but differing coupons: lower coupon bonds have more price volatility than higher coupon bonds – the discounting impact will be greater in bonds with a smaller coupon. The maturity effect: Two bonds with the same coupon but differing maturity, the longer term bonds have more price volatility than shorter term bonds (where the impact of discounting becomes more profound in the later years). [Total: 33 marks] Paper Code: «Module» Page 16 of 20 Question 6 a) An investor has a four-year investment horizon and is choosing between buying a three- year zero coupon bond today followed by a one-year investment or buying a four-year zero coupon bond today. The three-year zero coupon bond is priced to yield 3.65% and the four-year zero coupon bond is priced to yield 4.18%. Required: i) What does the current four-year zero coupon rate suggest that the incremental one- year rate is in three years’ time? (3 marks) ii) If the investor’s view on future bond yields is that the one-year rate in three years is likely to be less than that suggested by the current four-year rate, what would their investment strategy be? (5 marks) Total: (8 marks) Suggested answer: (1.0418)4 (1.0365)3 − 1 = 5.79% • They would choose the 4-year bond today because rolling over the three year choice into one further year would yield less than the total return on the 4-year (according to the investor!!). • The four-year rate incorporates the current three year rate PLUS the forecast of where the market thinks the 1-year rate will be in three years time. • And the investor thinks that the actual 1-year rate in three years will be less than the 5.79%. b) Describe the characteristics of the passive and active approaches to equity investing. (13 marks) Paper Code: «Module» Page 17 of 20 Suggested answer: • Passive Management: the investor does not attempt to reflect his / her investment expectations through changes in security holdings. The most common passive approach is through an indexed portfolio (eg index mutual fund, ETF). – This involves investing in a portfolio that attempts to match the performance of some specified benchmark. – When a stock is added to or dropped from an index, or when the weight of a given stock changes because of a corporate action (dividend / stock split / rights issue), the indexed portfolio must also be adjusted (rebalanced). • Active Management: Arises when a fund manager seeks to outperform a given benchmark. He / she does this by identifying which stocks he/she thinks will perform comparatively well versus the benchmark. He needs to acquire information that he believes will give him a distinct advantage over his peers or simply interprets that information differently (gathered by team of equity analysts). They buy and hold the latter stocks and avoid those stocks which they believe will underperform the benchmark. Periodically, they will review their stock choices and their performance. They may change their stock choices if new information comes to the market concerning their prospective performance or if they identify other stocks that they think will perform comparatively well versus the benchmark. It involves higher management fees and transaction costs - they will need to be offset by superior performance versus the BM index. The risk profile / exposures and subsequent tracking error differs from the BM index – consistent with trying to outperform it. Paper Code: «Module» Page 18 of 20 c) The Techno Co. recently paid a dividend of $1 per share. Analysts expect its dividend to grow at 25% per year for the next three years and then at 5% per year indefinitely thereafter. Required: i) If the required rate of return on the stock is 18%, what is the current value of the stock? (7 marks) ii) Is the Gordon Growth Model suitable to apply to all companies? (5 marks) Total:(12 marks) Suggested answer: Only those who actually pay dividends and have a dividend paying history to refer to in relation to estimating growth (not if recently gone through IPO) Relatively insensitive to business cycles and large fluctuations in earnings growth and subsequent dividends. Mature companies. 1 × 1.25 1 × 1.252 1 × 1.253 1 × 1.253 × 1.05 1 0 = (1 + 0.18) + (1 + 0.18)2 (1 + 0.18)3 + [ (0.18 − 0.05) × (1 + 0.18)3 ] 0 = 1.06 + 1.12 + 1.19 + 9.60 = 12.97 [Total: 33 marks] Paper Code: «Module» Page 19 of 20 T Formula sheet r = WACC = k B + k S assets b B + S s B + S No corporate tax r = WACC = k (1− t ) B + k S assets b c B + S s B + S A corporate tax rate = tc CAPM: () = + ( − ) d = ln(S / X ) + rFT + 1 1 2 d2 = d1 − C = S[N(d1)] – X [N(d2)] e-rt T T Paper Code: «Module» Page 20 of 20
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