Sem 2, 2011, Final Examination

Business Finance PG

Section- A : Multiple Choice Questions Answer all questions Instructions: Provide your answers to the multiple-choice questions on the first page of your answer booklet.
Section-A: [Total = 10 marks, 1 mark for each question]
Multiple Choice: Select the most appropriate answer and record your choice on the first page of your answer booklet not on this exam paper. On the first page of your answer booklet list the numbers 1 to 10 to answer the multiple choice questions, with each number on a separate line.
Next to each question number enter one letter (A, B, C etc.) that you have chosen as the correct answer for the multiple-choice question .Form example, Answers: 1 2 3 A B C

Section-B: Discussion / Calculation Questions

Section B: [Total = 40 marks]

Instructions: Start each question on a new page. Answer any two (2) questions out of B-1, B-2 & B-3. Answer any one (1) question out of the remaining B-4 & B-5.

SAMPLE STYLE/STRUCTURE OF THE EXAM QUESTIONS in Section- B **(The students need to be aware that actual exam questions can be from any topic/ chapter covered in the subject/ unit)
QUESTION B-1 (Total Mark= 20) You have some money to invest for 12 months and you are considering purchasing some share in either company A or company B. After reviewing the historical performance and future prospects for both companies you have prepared the following table. Share A Current share price Current EPS Current beta Probability of Return 0.25 0.40 0.35 $1.50 $0.20 0.90 Return over next 12 mths 1% 12% 14% $2.10 $0.15 0.55 Probability of Return 0.20 0.30 0.30 0.20 Current risk free rate of return: 4% pa Current return on a market portfolio 11% pa REQUIRED a) b) c) d) e) f) Calculate your expected annual return for each share. (4 marks) Calculate the return you should require for each share. (4 marks) Draw a graph of the security market line and, based on your answer to (b) above, plot shares A and B on the graph. (2 marks) Calculate the price you would be prepared to pay for each share. (4 marks) Identify which share you would buy and briefly explain the reasons for your choice. (3 marks) Briefly detail the implications arising from your answers above for the operation of the share market. Return over next 12 mths 2% 6% 11% 16% Share B

Sem 2, 2011, Final Examination

Business Finance PG

(3 marks) (Show all workings/ Calculations)

Question B-2 [Total = 30 marks] a) Your nephew Hans Valen, who has worked in the printing industry for the last five years, has decided to go into business for himself by opening a small print shop. He has asked you to help him with some analysis of his business plan. From the detailed costs he has provided, you have categorised them into fixed and variable cost. Fixed costs total $100,000 while variable costs comprise 60% of sales. Required: i) What level of sales will Hans Valen have to achieve before he starts to earn a profit? (3 marks) ii) While Hans Valen hopes to achieve sales of $400,000 he is not certain of this figure. Calculate the percentage impact on EBIT of sales exceeding or falling short of this estimate by 20%. (6 marks) iii) What is the degree of operating leverage assuming that sales could vary by 20% from estimates? (5 marks) The Knotted Noodle Company is planning to open a new production plant in Malaysia, costing $1,000,000. It can fund this expansion through either Plan A, a debt issue of $l00 face value bonds paying an annual coupon of $l0 per bond, or Plan B, the issue of new shares at $1 each. It currently has $500,000 of bonds paying 8% p.a. interest, and 2,000,000 shares on issue. The current EBIT is $320,000, and the company pays tax at 30% on earnings. Required: i) What is Knotted Noodle Company's current earnings per share (EPS)? Show all calculations. (6 marks) ii) If the new plant will add $160,000 to EBIT, which of the financing plans will produce the higher earnings per share? Show all calculations. (4 marks)

b)

iii)

Why may shareholders not prefer this plan even though it has the higher EPS? (3 marks) Calculate the EBIT (level) indifference point at which the EPS will be the same for both the financial plans. (3 marks) (Show all workings/ Calculations)

iv)

Question B-3 (13 marks) The Clysdale Company has an optimal capital structure consisting of 60 percent debt and 40 percent equity. The cost of capital is calculated to be 15 percent. Total earnings available to ordinary shareholders for the coming year total $1 500 000. Investment opportunities are: Project A B C D Investment $1 500 000 160 000 750 000 240 000 21 19 16 13 IRR (%)

a. According to the residual dividend theory, what should the firm's total dividend payment be? (7 marks) b. If the firm has 1,000,000 shares, calculate the dividend per share based the calculation in (a) above (3 marks) c. If the firm paid a total dividend of $500 000, and restricted equity financing to internally generated funds, which projects should be selected? Assume the cost of capital is constant. (3 marks) (Show all workings/ Calculations)

r = 11% Sem 2, 2011, Final Examination r = 10.3% r = 9.95% SOLUTION GUIDELINES r = 8.7% Question B-1: Solution Guidelines [Total = 20 marks] r = 7.85%
a) Expected Return A

Business Finance PG

r = 4%
.25 .40 .35 0

SML
1% 12% 14% A .25 4.80 .2 .3 .3 .2

B 2% 6% 0.40 1.80 3.30 3.20 8.7

Beta B = .55 Beta A = .90

9.95

4.90

Beta=1

11% 16% B

b)

Required Return CAPM ri = rf + (rm - rf) A = 4% + (11 - 4) .90 = 10.3% B = 4% + (11 - 4) .55 = 7.85%

c) The graph is logically but arbitrarily drawn (the graph has been redrawn to make it clearer. The formatting changes shape of original drawing, however, it is clearer now.)

d)

Price you would be prepared to pay

eps re

$0.20 = $194 . .103 $015 . = $191 . 0.0785

B e)

Buy share A because it is under priced in the market at $1.50. To provide the return for the risk ( = .90) it should be priced at $1.94. In other words at $1.50
$.20 = 13.33% . investors can obtain a return of $150 whereas they should only be

compensated for 10.3% for the exposure to beta risk. Share B on the other hand is overpriced as it is valued at $2.10 in the market whereas investors should only pay $1.91 to provide the return of 7.85%. f) You can conclude that the market is not operating efficiently because the shares are mis-priced on the basis of available information of beta risk and return.

Question B-2: Solution Guidelines [Total = 30marks] a) i) S = F = l00,000 = 1 - VC / S1 -0.6 Hence breakeven sales = $250,000 ii) Sales Var. Costs Fixed Costs EBIT Current $ 400,000 240,000 160,000 100,000 60,000 250,000

20 lower sales $ 320,000 192,000 128,000 100,000 28,000

% change in EBIT = ($32,000 / 60,000) = 0.533% The % change in EBIT = 53.3%

Sem 2, 2011, Final Examination

Business Finance PG

iii)

DOL = % change EBIT = 53.3% / 20 = 2.67 times % change SALES The degree of operating leverage is 2.67 times EBIT less interest 320,000 40,000 280,000 less tax 84,000 196,000 EPS = 196,000/ shares on issue = 196,000/ 2,000,000 = 0.098 The firm's EPS is currently 9.8 cents Plan A EBIT 480,000 less interest 140,000 340,000 less tax (0.3) 102,000 238,000 No. of Shares 2m EPS 0.119 Plan B 480,000 40,000 440,000 132,000 308,000 3m 0.103

b) i)

ii)

Hence the expected EPS of Plan A is 11.9 cents and 10.3 cents for Plan B Select Plan A (the debt issue) as it produces the higher EPS iii) iv) Shareholders may not prefer Plan A as it involves the use of a higher proportion of debt than Plan B thus increasing financial risk. The higher risk of Plan A may offset the benefit of the higher return (EPS). EPS= {(1-T) X (EBIT-I)-Dp}/n; where T= tax rate, I= total interest payment, Dp= preferred dividend and n= number of shares outstanding.

EPS from both the project will be equal if, {(1-0.3) X (EBIT-140,000)-0}/2,000,000} = {(1-0.3) X (EBIT-40,000)-0}/3,000,000} Solve for EBIT.

Question B-3: Solution Guidelines [Total = 13 marks] a. Select projects A, B and C for a total investment of $2 410 000 (that is, all investments with an IRR greater than the company's cost of capital). Of this total investment: $2 410 000 0.60 = $2 410 000 0.40 = Dividend payment b. c. = $1 446 000 debt $964 000 equity $1 500 000 - $964 000= $536 000

$536,000/1,000,000 = 0.536 $1 500 000 - $500 000= Choose project A only. $1000 000 for investment