LANCASTER UNIVERSITY
MOCK EXAM
AcF502
FOUNDATIONS OF FINANCE
Time: 2 hours
(+15 minutes reading time)
Instructions
1.
This is a closed book exam.
2.
The exam will last exactly 120 minutes (plus 15 minutes reading time).
3.
The exam consists of two questions. You must answer BOTH questions.
4.
Answer ALL subparts of the questions and show all your workings to receive full marks.
5.
You may plan your answers on scrap paper.
6.
Answer each question in a separate answer booklet.
7.
A formula sheet is provided in the last page of this question paper.
8.
For calculation questions, please round up your answer to 2 decimal places.
9.
For explanation questions, please be precise and try to answer the question within 4 sentences.
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You must answer BOTH questions.
Answer ALL subparts of the two questions.
Question 1
The XYZ Company is a highly profitable, major manufacturer of telephone equipment in the Country A.
One year ago, XYZ invested $1 million in plant and machinery, to start a new manufacturing plant in
Southern A. The aim was to launch a new product from this facility. However, due to various technical and
marketing problems, the plant did not commence production last year. Given the current market conditions,
the Finance Manager now feels that the company should discontinue the project immediately. But the Chief
Executive thinks it would be a mistake to abandon the project.
If the project goes ahead, it will last for four years. Since the machinery has not been in use for one year, the
company would have to call in FixTheMachine plc to service the machinery immediately at a cost of
$50,000. Sales (minus direct manufacturing costs) at the plant are expected to be $ 300,000 in year 1, rising
by $50,000 per annum over the following three years. As a result of the new product launch, the existing
sales (minus direct costs) at the company's other plants are expected to be $50,000 lower in year 1 and
$60,000 lower in year 2. There will be no effect on existing net sales in year 3 and thereafter. If the project
goes ahead, the plant will have to hold stock of $100,000 throughout the life of the project. For tax purposes,
the plant and machinery are to be fully depreciated (straight line) over the 5 year life of the project (i.e.
starting from the time the equipment was bought one year ago). However, at the end of the 4th year of the
project (i.e. 5 years after the plant and machinery were purchased), the company would expect to sell the
plant and machinery for $200,000.
The company accountant estimates that overhead expenditure at the plant would be $60,000, but half of this
represents an apportionment of current overhead costs.
Mr Bell, the manager of another branch in Northern A, has volunteered to oversee the new plant if the project
goes ahead, spending approximately 20% of his time on the new project. His has volunteered to oversee the
new project because the new plant is located close to his ancestral home. His current salary is $30,000 per
annum. If the project does not go ahead, he would simply carry on with his existing duties at the Northern
branch.
If the project does not go ahead, the plant and machinery can be sold immediately (in their current state) for
$800,000.
All cash flows are in nominal terms. Cash flows that occur during a year can be treated as taking place at the
end of that year. The corporate tax rate is 33%. Taxes are paid one year in arrears. The annual rate of inflation
is 1%. The expected real rate of return on the market portfolio is 6.93%. The nominal rate of return on riskfree securities is expected to be 3%.
The unlevered company and project betas are thought to be 1.2 and 1.4, respectively.
The company has asked you to perform an NPV calculation to help resolve the dispute between the Chief
Executive and Finance Manager. You may assume that the CAPM is valid.
REQUIRED
Compute the NPV and IRR of the project
(TOTAL 50 MARKS)
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Question 2
A. You have the following information for Alpha plc:
Equity: 500,000 shares. The company just paid a dividend of £2 and the dividends are expected to
grow by 3% per year indefinitely. The current share price is £20. The return of Alpha’s equity has a
standard deviation of 24% per annum and a correlation with the market of 0.9.
Debt: 10,000 bonds outstanding, with 20 years to maturity, a coupon rate of 7% and a face value of
£1,000. The price of the bonds is £901.036 and they pay coupons semiannually.
The market risk premium is 6% and the standard deviation of the returns of the market is 15%.
Treasury bills are yielding 4% and the corporate tax rate is 20%.
REQUIRED
i)
ii)
iii)
iv)
Calculate the cost of equity using the dividend growth model.
(3 marks)
Calculate the cost of equity using the security market line (SML) method. (6 marks)
What is Alpha’s weighted average cost of capital (WACC)?
(8 marks)
Now assume that you are financial manager of Alpha plc, and you have been asked by one of
your large shareholders the following questions, “If debt can reduce the weighted average cost
of capital, why does it then increase the risk of a company? Is it possible for financial manager
to diversify bankruptcy risk away like other risks?” What are your answers to these questions?
Explain. (6 marks)
B. Alpha Corporation and Beta Corporation are identical in every way except their capital structures.
Alpha Corporation, an all-equity firm, has 5,000 shares of stock outstanding, currently worth $20
per share. Beta Corporation uses leverage in its capital structure. The market value of Beta’s debt is
$25,000. The cost of this debt is 12% per annum. Each firm is expected to have earnings before
interest of $350,000 in perpetuity. Neither firm pays taxes. Assume that every investor can borrow
at 12% per annum. Assume no corporate taxation.
REQUIRED
i)
ii)
iii)
iv)
v)
What is the value of Alpha Corporation? (3 marks)
What is the value of Beta Corporation? (3 marks)
What is the market value of Beta Corporation’s equity? (4 marks)
How much will it cost to purchase 20% of each firm’s equity? (5 marks)
Assuming each firm meets its earnings estimates, what will be the dollar return to each position in
part (d) over the next year? (5 marks)
vi) Construct an investment strategy in which an investor purchases 20% of Alpha’s equity and
replicates both the cost and dollar return of purchasing 20% of Beta’s equity. (7 marks)
(TOTAL 50 MARKS)
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END OF EXAM
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