SCHOOL OF SOCIAL SCIENCES Edinburgh Business School Course Name: Corporate Financial Theory Course Code: C39FN MOCK TEST October 2023 INSTRUCTIONS Section A: Answer ALL questions. Section B: Answer ALL questions. Show all workings where applicable. Section A Question 1 Riccarton Plc is considering investing in a project with the following cash flows: Year Net cash flow(£) 1 1,000 2 1,500 3 2,000 4 1,750 5 1,500 6 1,000 7 500 8 500 The firm has a required rate of return of 10% and a benchmarks payback of 5 years. The initial investment is £ 6,250. Answer the following. a) Calculate the payback period and comment on whether the project can be accepted. Justify your recommendation. (6 Marks) b) Calculate the exact discounted payback and comment on whether the project can be accepted. Justify your recommendation. (8 Marks) c) Calculate the Net Present Value of the project. (8 Marks) d) Advise the management of the company on whether to accept or reject the project. Justify your recommendation. (3 Marks) e) The project above does not yet take inflation into account. Explain briefly how you would incorporate a nominal inflation rate of 5% into the calculation? (5 marks) Total: 30 marks Continued on next page \... Question 2 a) HW Plc has undertaken an investment project with an expected life of three years. The future cash flows of the project are as follows: Year Sales revenue (£000) Costs (£000) Tax benefits (£000) 1 2 3 1,300 2,600 5,000 500 1,000 2,000 150.00 112.50 337.50 These forecast cash flows have taken into account the general inflation of 4% per year. The capital cost of the investment project, payable at the start of the first year, will be £2,000,000. The investment project will have zero scrap value at the end of the third year. The capital cost of the investment project, payable at the start of the first year, will be £2,000,000. The investment project will have zero scrap value at the end of the third year. Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis. HW plc pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. HW plc has a nominal (money terms) after-tax cost of capital of 12% per year. Required: Calculate the Net Present Value (NPV) of the investment project in real terms and comment on its financial acceptability. (20 marks) Continued on next page \... b) An investor purchasing a British CONSOL is entitled to receive annual payments from the British government forever. What is the price of console that pays £120 annually if the next payment occurs one year from today? The market interest rate is 15 percent. (10 marks) Total: 30 marks Section A Total: 60 marks Section B Question 1 a) Financial analysts use incremental cash flow in projected analysis. Do you agree with this statement? Explain (10 marks) b) Briefly explain the difference between the following sunk costs and opportunity costs in capital projects (10 marks) Question 2 Explain the irrelevancy argument for capital structure put forward by Modigliani and Miller’s famous Proposition I. (20 marks) Section B Total: 40 marks Total Test Marks: 100 marks -END OF MID-TERM TEST PAPER – SOLUTIONS Section A Question 1 a) The payback period Payback is the length of time for cumulated future cash inflows to equal an initial outflow. We accept projects if this time is below an agreed cut-off point. For this project the payback = 4 year Since the benchmark payback period for this firm is 5 years, we can accept the project. b) The discounted payback Year Net cash flows£ Discount factor Discounted cash flow 0 1 2 3 4 5 6 7 8 (6,250) 1,000 1,500 2,000 1,750 1,500 1,000 500 500 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 (6,250) 909.1 1,239.6 1,502.6 1,195.3 931.3 564.5 256.6 233.3 Cumulative discounted cash flow (6,250) (5,340.9) (4,101.3) (2,598.7) (1,403.4) (472.1) 92.4 349.0 582.3 Then: discounted payback = 5 + (472.1/564.5) = 5.84 years Since the benchmark payback period for this firm is 5 years, we cannot accept the project based on the discounted payback period method. c) The net present value Net present value (NPV) = £ 582.30 d) Since the NPV of £582.30 is positive, we can accept the project. Provide additional explanation and why a positive NPV is beneficial to the company. Question 2 a) Year 0 1 2 3 4 £000 £000 £000 £000 £000 Sales revenue 1,300 2,600 5,000 Costs (500) (1,000) (2,000) Net revenue 800 1,600.00 3,000.00 Tax payable (240) (480) (900) CA tax benefits 150 112.5 337.5 800 1,510.00 2,632.50 (562.5) 0.926 0.857 0.794 0.735 740.74 1,294.58 2,089.76 (413.5) Initial Investment After tax cash flow (2000) (2000) Discount at 8% Present values (2000) £000 PV of future cash flows Initial investment NPV 3,711.63 (2,000.00) 1,711.63 The net present value is 1,711,630 (positive) and so the investment project is financially acceptable. b) The price of any bond is the present value of its coupon payments. Since a consol pays the same coupon every year in perpetuity, apply the perpetuity formula to find the present value. PV = C1 /r = 120/0.15 = £800 The price of the consol is £800. Section B Question 1 a) To undertake capital budgeting or investment appraisal, financial analyst use cash flows to determine the value of the project. Incremental cash flows are the net additional cash flows generated by a company by undertaking a project. Accountant use accounting values generated based on accounting principles such as accrual concept to calculate values like income, expenses, profit and loss. Financial analyst, on the other hand, use cash incremental cash flow to determine the actual cost of a project and the projected earnings. b) Sunk costs are costs that have already been incurred and thus the money has already been spent. Opportunity costs are cash flows that could be realized from the next best alternative use of an owned asset. Sunk costs are not relevant to the investment decision because they are not incremental. These costs will not change with the final accept/reject decision. Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made not to change the current asset structure but to utilize the owned asset for this alternative purpose. Question 2 i) To obtain MM Proposition I, we make assumptions: • Homogeneous expectations • Homogeneous business risk • Perpetual cash flows • Perfect capital market • Perfect competition (everyone is a price taker) • Firms and investors can borrow and lend at the same rate • Equal access to all relevant information No transaction cost (taxes or bankruptcy costs) MM Proposition I concerns the irrelevancy of capital structure to the value of the firm. The value of the levered firm, VL, must be equal to the value of the unlevered firm, VU (if there are no taxes considered). The firm's market value and average cost of capital are completely independent of the capital structure that the firm chooses. That is: VL = VU where • VU is the value of an unlevered or all equity firm • VLis the value of a levered firm (a firm which has some debt in its capital structure). MM -- Graphical Representation In a world with no corporate taxes, the MM Propositions can be represented graphically as follows: This theory is valid under certain conditions. Although the theory is far from true, so are the conditions. An understanding of the MM's theory helps us to understand those conditions, which, in turn, helps us to understand why a particular capital structure is better than another. In addition, the theory tells us what kinds of market imperfection we need to look for and pay attention to. The imperfections that are most likely to make a difference are taxes, the costs of bankruptcy and the costs of writing and enforcing complicated debt contracts.