December 2021 – Semester A - Timed Examination
Module Code and Title: BUS 306 Financial Management
Date of exam: 17 December 2021
Question 1
Achieving the long-term financial objectives of a company will involve the financial manager in
making decisions regarding investment and financing.
a) Explain the nature of these two types of decision and the extent to which they are inter-related.
Investment refers to decision as to how to allocate money, or simply put spend money, in
the most effective way that will yield the highest return in a set time-period. Financing refers to
companies’ ability to pay its ‘bills’ so to say, which can be done from its own funds or external
capital, with two options of external capital coming from selling equity or taking on debt. The
nature of these two are inter-related as every investment needs to be financed. The process of
financing decision is tasked with the optimal way to do that. One is always accounted for the other
with the primary goal being of maximizing shareholder value.
b) Indicate which of the two categories of financial decision you consider to be the most important,
giving your reasons.
I consider the financing decision to be the most important as it is the operation that is essential to
company function. Even for the investment decisions are impossible to be made without financial
decisions taking place. While the investments increase assets and company value and yield returns,
none of them would be possible without proper financial decisions and analysis. Correct allocation
of loans, debt, equity, cash on hand, is the single most important thing to companies to maintain a
healthy financial standing.
Question 2
a) In relation to long-term debt, explain the meaning of the term ‘sinking fund’. Explain why
bondholders often prefer a sinking fund provision in a bond issue.
A sinking fund is money set aside to pay off the bonds at maturity, which increases the
companies creditworthiness as there is less chance of default on maturity payments. Bondholders
prefer a sinking fund provision in a bond issue as it is a lower risk investment.
b) Philips Industries has bonds outstanding with a $1,000 par value that mature 12 years from
today and have a coupon interest rate of 10 percent.
Calculate the maximum price an investor should be willing to pay if the investor desires an 8
percent yield-to-maturity.
Face Value of bond = $1,000
Coupon rate= 10%
Years to maturity = 12 years
Yield to Maturity= 8%
Annual coupon payment= Face value x Coupon rate = $1,000 x 10%=$100
Bond price = Present value of Coupon payments + Present value of maturity value
= Coupon payment × PVIFA8%,12 + Facevalue × PVF8%,12
=$100 x 7.536 + $1,000 x 0.397=753.6+397=1150.6
ii) Determine the change in the price of the bond if investors now require a rate of return of 14
percent due to the increased risk in the economy.
Bond price = coupon payment x PVIFA14%,12 + Face value × PVIF14%,12
= $100 x 5.660 + $1,000 x 0.208=566 + 208 = 774
The change in the price of the bond is 1150.6-774=376.6
Question 3
a) The expected return derived from the constant growth rate dividend model depends on two
forms of return an investor can expect to receive from holding common stock.
Explain the two forms of return.
The two forms of return are dividends, which is a fraction of profits distributed to
shareholders on a set schedule, or by increasing the value of stock, hence the per share worth is
constantly growing.
The stock of Dravo Corporation currently pays a dividend (D0) at the rate of $2 per share. This
dividend is expected to increase at a 9 percent annual rate for the next three years, at a 7 per cent
annual rate for the following two years, and then at 4 per cent per year thereafter. What is the
value of a share of stock of Dravo to an investor who demands a 24 per cent rate of return on this
stock?
b) A fast growing firm recently paid a dividend of $0.35 per share. The dividend is expected to
increase at a 20 percent rate for the next three years. Afterwards, a more stable 12 percent growth
rate can be assumed. The cost of capital is 13%. Calculate the value of the stock.
Year
Dividend
Present Value Interest Factor
Present Value
t
Dt = 0.35(1+g)
PVIF(0.13,t)
1
0.35(1.2)^1 = .42
.885
.372
2
0.35(1.2)^2=.504
.783
.329
3
0.35(1.2)^3=.605
.693
.419
PV (First 3-Years’ Dividend)
Dt x PVIF (0.13,t)
$1.120
Value of Stock at the end of year 3:
P3=D4 / ((ke - 0.12)
D4= D3(1.12)=.605(1.12)=$.6776
P3=$0.6776/(0.13-0.12)=$67.76
Value of P3:
PV(P3)=P3/(1+ke)^3=$67.76 x PVIF(0.13,3)= $67.76 x 0.693 =$46.957
Value of Common Stock (P0):
Po=PV(First 3-years’ Dividends) + PV (P3)= $1.120+$46.957=$48.077
Question 4:
Docklands Trading Ltd is considering the selection of one of a pair of mutually exclusive investment
projects. Both would involve purchase of machinery with a life of five years.
Project 1 would generate annual cash flows (receipts less payments) of £200,000, the machinery
would cost £556,000 and have a scrap value of £56,000.
Project 2 would generate annual cash flows of £500,000, the machinery would cost £1,616,000 and
have a scrap value of £301,000.
Docklands uses the straight line method for providing depreciation over the useful life of the
machinery. The cost of capital is 15% per annum. Assume that annual cash flows arise at the end of
the relevant year and that there will be no price changes over the project lives.
a) Calculate for each project:
1. (i) the net present value
Project 1:
Initial Investment 556,000
PV of annual Cash Flow=200,000 x PVIFA(0.15, 5)= 200,000 x 3.35=670,000
Scrap Value = 56,000 x PVIF(0.15, 5)= 56,000 x .497= 27,832
NPV= (670,000+27382)-556000=141,832
Project 2:
Initial Investment 1,616,000
PV of annual Cash Flow= 500,000 x PVIFA(0.15, 5)= 500,0003.35=1,675,000
PV of scrap value=301,000 x PVIF(0.15, 5)=149,597
NPV= (1,675,000 + 149597) – 1616000 = 208,597
2. (ii) the payback period
Pay back period= initial investment/annual cash flow
Project 1= 556,000/200,000=2.78 years
Project 2= 1,616,000/500,000=3.23 years
b) State which project you would select and give reasons for your selection.
I would select project 1 as it has a higher average rate of return with a lower initial
investment. Even though project 2 offers a higher return, it requires a higher initial investment and
longer pay back period.
c) Which of the two investment appraisal methods above offers a better approach to appraising the
projects? Justify your answer.
While each method is targeting a specific metric, be that time or financial return, it comes
down to which one you deem more important. In my personal opinion, Pay Back Period is better at
appraising the projects as the money can be re-invested another project sooner. However, NPV
always needs to be considered and compared to understand if the extra time spent on the project is
justified with proportionally higher returns.
Question 5:
a) Under what situations would you want to use the CAPM approach and the constant growth
model for estimating the component cost of equity?
CAPM is better used in situations with enough historical observation to be able to
accurately estimate beta of the stock, and it is believed that the historical data is a fair
indicator of the future risk. The constant growth model is best used when there is
certainty the company is expected to have constant dividend growth.
b) Canary Wharf plc has a present capital structure (which the company feels is optimal) of 50
percent long-term debt,10 percent preferred stock, and 40 percent common equity. The company
has determined that its optimal capital budget can be externally financed in the forthcoming year
with $70 million of 10 percent bonds sold at par and $14 million of preferred stock costing the
company 11 percent. The remainder of the capital budget will be financed with retained earnings.
The company’s common stock is presently selling at $25 a share, and next year’s common dividend,
is expected to be $2 a share. The company has 25 million common shares outstanding. Next year’s
net income available to common stock (including net income from next year’s capital budget) is
expected to be $106 million. The company’s past annual growth rate in dividends and earnings has
been 6 percent. However, a 5 percent annual growth in earnings and dividends is expected for the
foreseeable future. The company’s marginal tax rate is 20 percent.
Calculate the company’s weighted cost of capital for the coming year.
After tax cost of debt= Before tax cost of debt x (1-tax rate)=10% x (1-20%)=8%
Internal Cost of Equity= (D1/Selling stock price) + g = 2/25 + 5%= 13%
Cost of Capital=After tax cost of debt x 50% + Cost preferred stock x 10%+ Cost of internal equity x
40%=
=(8% x 50%)+(11%x10%)+(13%x40%)=10.3%