ASTON UNIVERSITY

EM4001
Aston University
School of Engineering & Applied Science
EM4001: Strategic Finance
Examination
Friday, 27th March 2009
14.00 – 16.00
Instructions to Candidates:
1.
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11.
Begin each question on a fresh page of the answer book.
Candidates must write legibly: illegible work cannot be marked.
Candidates must write in ink: pencil work is not marked.
All workings must be submitted: if you do not wish a working to be
read, you should put a line through it.
Candidates must enter the question numbers of ALL answers
submitted on the front page of their first answer book completed.
Where more than one answer booklet is submitted, the booklets
should be loosely tied together.
Candidates should always give reasons for their answers.
In marking the papers, the examiners will take into account the
relevance of answers, clarity of exposition (including the use of
concise and lucid English), logic of arguments, and effective
structure and presentation.
This paper contains THREE questions of which candidates should
answer any TWO.
All questions are of equal mark value.
Do not turn this page until you are told by an invigilator that you may
do so.
Materials provided:
1.
2.
Answer booklet.
Calculator.
This is a closed book examination.
This examination is subject to the Examination Regulations for Candidates REG/99/281(4)
Page 1 of 5
Question 1
Bax Ltd is a company whose Board is considering expansion. Six profitable
investment opportunities have been identified, but investment funds available
are restricted to £600,000. The projects are not divisible and can not be
postponed to a later date.
Project
Red
Black
Yellow
Green
Gold
Blue
Year 0
£000
(245)
(180)
(180)
(180)
(170)
(145)
Year 1
£000
72
76
50
65
40
40
Year 2
£000
72
88
50
65
55
80
Year 3
£000
72
65
60
65
65
80
Year 4
£000
72
Year 5
£000
72
70
65
65
20
Projects Red and Gold are mutually exclusive. The projects are believed to
be of similar risk to the company’s existing projects. Surplus funds cannot be
used to generate further net present value (NPV). The historical cost of
capital of Bax Ltd is 12% p.a.: however, the CEO of the company argues that
the relevant discount rate is the internal rate of return on the best project
rejected because of the budget constraint.
Required:
(a)
(b)
(c)
(d)
Calculate the expected NPV and profitability index (PI) for each of the
projects,
(40%)
Rank the projects, firstly by NPV and, secondly, by (PI), explaining why
the rankings may differ,
(10%)
Advise the Board of Bax Ltd as to which projects should be selected,
briefly justifying your approach,
(40%)
Comment on the CEO’s claim regarding the most appropriate discount
rate.
(10%)
[Total 100%]
This examination is subject to the Examination Regulations for Candidates REG/99/281(4)
Page 2 of 5
Question 2
Rossini plc is identical in all operating and risk characteristics to Wagner plc,
except in terms of capital structure: Rossini plc is financed by equity, whereas
Wagner plc is financed by a mixture of debt and equity. The market values of
Wagner plc’s debt and equity are £2.1m and £0.9m, respectively. To service
its debt, Wagner pays £72,000 p.a., and the company pays an annual
dividend of £378,000. Rossini plc pays a dividend of £450,000 p.a.
Required:
(a)
Calculate the market value of Rossini plc,
(5%)
(b)
Calculate the cost of capital for Rossini plc,
(5%)
(c)
Calculate the cost of equity for Wagner plc,
(10%)
(d)
Calculate the cost of debt for Wagner plc,
(e)
Calculate the weighted average cost of capital for Wagner plc
(10%)
(f)
(10%)
In a world where debt tax relief is available at 30%, calculate the
weighted average cost of capital for Wagner plc.
(60%)
[Total 100%]
This examination is subject to the Examination Regulations for Candidates REG/99/281(4)
Page 3 of 5
Question 3
Polly plc is a company that has recently secured a stock exchange listing. It
is currently financed exclusively by equity, although the Board is considering
introducing debt into the company — with market values of debt to equity in
the ratio of 1:2. There is insufficient historical data for the CAPM to be applied
directly to Polly plc, but there is an equivalent geared company, Toby plc, that
is funded by 70% equity and 30% debt. Toby plc has an equity beta of 1.2.
Corporation tax is charged at 30%, the risk-free rate of return is 6%, and the
market rate of return is 12%.
The Board of Polly plc proposes to invest in a new project that would involve
diversification into a new industry; in this industry the mean debt to equity ratio
is 1:3, by market value, and the mean beta for equity capital is 1.5.
Required:
(i)
(ii)
(iii)
Calculate the expected existing return on the equity of Polly plc if the
company remains all-equity financed,
(25%)
Calculate the expected existing return on the equity of Polly plc if debt
were to be introduced in the proportion envisaged by the Board,
(25%)
Assuming that Polly plc does introduce debt in the proportion
envisaged by the Board, estimate a suitable cost of capital to apply to
the new project.
(50%)
[Total 100%]
END OF QUESTIONS
This examination is subject to the Examination Regulations for Candidates REG/99/281(4)
Page 4 of 5
Table of Discount Factors
This table gives the present value of a single payment received n years in the
future discounted at r% per annum. For example, a single payment of £1
received in two years time discounted at 25% per annum has a present value
of £0.640, or 64p.
n
1
2
3
4
5
1%
0.990
0.980
0.971
0.961
0.952
2%
0.980
0.961
0.942
0.924
0.906
3%
0.971
0.943
0.915
0.889
0.863
4%
0.962
0.925
0.889
0.855
0.822
5%
0.952
0.907
0.864
0.823
0.784
6%
0.943
0.890
0.840
0.792
0.747
7%
0.935
0.873
0.816
0.763
0.713
8%
0.926
0.857
0.794
0.735
0.681
9%
0.917
0.842
0.772
0.708
0.650
10%
0.909
0.826
0.751
0.683
0.621
n
1
2
3
4
5
n
1
2
3
4
5
11%
0.901
0.812
0.731
0.659
0.594
12%
0.893
0.797
0.712
0.636
0.567
13%
0.885
0.783
0.693
0.613
0.543
14%
0.877
0.770
0.675
0.592
0.519
15%
0.870
0.756
0.658
0.572
0.497
16%
0.862
0.743
0.641
0.552
0.476
17%
0.855
0.731
0.624
0.534
0.456
18%
0.847
0.718
0.609
0.516
0.437
19%
0.840
0.706
0.593
0.499
0.419
20%
0.833
0.694
0.579
0.482
0.402
n
1
2
3
4
5
n
1
2
3
4
5
21%
0.826
0.683
0.565
0.467
0.386
22%
0.820
0.672
0.551
0.451
0.370
23%
0.813
0.661
0.537
0.437
0.355
24%
0.807
0.650
0.525
0.423
0.423
25%
0.800
0.640
0.512
0.410
0.328
26%
0.794
0.630
0.500
0.397
0.315
27%
0.787
0.620
0.488
0.384
0.303
28%
0.781
0.610
0.477
0.373
0.291
29%
0.775
0.601
0.466
0.361
0.280
30%
0.769
0.592
0.455
0.350
0.269
n
1
2
3
4
5
Annuity Table
This table gives the present value of £1 receivable at the end of each year for
n years at a discount rate r%. For example, a payment of £1 received at the
end of each year for four years discounted at 10% per annum has a present
value of £3.170, or 317p.
n
1
2
3
4
5
1%
0.990
1.970
2.941
3.902
4.853
2%
0.980
1.942
2.884
3.808
4.713
3%
0.971
1.913
2.829
3.717
4.580
4%
0.962
1.886
2.775
3.630
4.452
5%
0.952
1.859
2.723
3.546
4.329
6%
0.943
1.833
2.673
3.465
4.212
7%
0.935
1.808
2.624
3.387
4.100
8%
0.926
1.783
2.577
3.312
3.993
9%
0.917
1.759
2.531
3.240
3.890
10%
0.909
1.736
2.487
3.170
3.791
n
1
2
3
4
5
n
1
2
3
4
5
11%
0.901
1.713
2.464
3.102
3.696
12%
0.893
1.690
2.402
3.037
3.605
13%
0.885
1.668
2.361
2.974
3.517
14%
0.877
1.647
2.322
2.914
3.433
15%
0.870
1.626
2.283
2.855
3.352
16%
0.862
1.605
2.246
2.798
3.274
17%
0.855
1.585
2.210
2.743
3.199
18%
0.847
1.566
2.174
2.690
3.127
19%
0.840
1.547
2.140
2.639
3.058
20%
0.833
1.528
2.106
2.589
2.991
n
1
2
3
4
5
END OF PAPER
This examination is subject to the Examination Regulations for Candidates REG/99/281(4)
Page 5 of 5