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.