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Examination Paper for International Students

Research on Financial Management 2015-6


1. Minitech Corporation is expanding rapidly and investors expect it to begin paying
dividends of $1.00 next year. The dividend should grow rapidly at a rate of 50% per year
during year 2 and year 3. After year 3, the company should grow at a constant rate of 7%
per year. If the risk-free rate is 5%, and the market risk premium is 8%, the beta of
Minitech is 1.25.
Requirement:
(1)What is the theoretical value of the stock today?
(10 marks)
(2)What is the Efficient Market Hypothesis? What are the 3 forms of EMH? Whats your
opinion on EMH?
(10 marks)
2. Discuss the advantages and disadvantages of the following capital budgeting method:
(1) Payback period;
(2) Discounted payback;
(3) NPV;
(4) IRR;
(5) MIRR.

(20 marks)

3Please comment on the relation between accounting information quality and cost of
capital. Support your view with existing literature and research when necessary. (20 marks)
4. What is agency theory? Explain how corporate governance and other mechanisms can
be arranged to reduce agency costs.
(20 marks)
5. What factors should be considered when making the decision on dividend policy?
(20 marks)

1) 1. Minitech Corporation is expanding rapidly and investors expect it to begin paying


dividends of $1.00 next year. The dividend should grow rapidly at a rate of 50% per year
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during year 2 and year 3. After year 3, the company should grow at a constant rate of 7%
per year. If the risk-free rate is 5%, and the market risk premium is 8%, the beta of
Minitech is 1.25.
Requirement:
(1)What is the theoretical value of the stock today?

Ks = 5% + 8% x 1.25 = 15%

FV

Discount factor

PV

D1

0.8695

0.87

D2

1 x 1.5 = 1.5

0.7561

1.13

D3

1 x 1.52 = 2.25

0.6575

1.48

P3

2.25 x 1.07 = 2.41/(15% - 7%) = 30.09

0.6575

19.79

P0 (the theoretical value of the stock today)

23.27

2. What is the Efficient Market Hypothesis? What are the 3 forms of EMH? Whats your
opinion on EMH?
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The Efficient-market hypothesis (EMH) states that it is impossible to "beat the market"
because stock market efficiency causes existing share prices to always incorporate and
reflect all relevant information. According to the Efficient-market hypothesis, stocks
always trade at their fair value on stock exchanges, making it impossible for investors to
either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be
impossible to outperform the overall market through expert stock selection or market
timing, and that the only way an investor can possibly obtain higher returns is by
purchasing riskier investments.
The Efficient-market hypothesis theory mentions that three forms of market efficiency
such as weak form efficiency, semi strong form efficiency and strong form efficiency.
Weak-form efficiency
In weak-form efficiency, future prices cannot be predicted by analyzing prices from the
past. Excess returns cannot be earned in the long run by using investment strategies based
on historical share prices or other historical data. Technical analysis techniques will not be
able to consistently produce excess returns; Prices must follow a random walk.
Semi-strong-form efficiency
In semi-strong-form efficiency, it is implied that share prices adjust to publicly
available new information very rapidly and in an unbiased fashion, such that no excess
returns can be earned by trading on that information. Semi-strong-form efficiency implies
that neither fundamental analysis nor technical analysis techniques will be able to reliably
produce excess returns.
Strong-form efficiency
In strong-form efficiency, share prices reflect all information, public and private, and
no one can earn excess returns. If there are legal barriers to private information becoming
public, as with insider trading laws, strong-form efficiency is impossible, except in the case
where the laws are universally ignored.

2) Discuss the advantages and disadvantages of the following capital budgeting method:
Payback period
The payback method is defined as the time, usually expressed in years, it takes for the
cash income from a capital investment project to equal the initial cost of the investment.
The choice between two or more projects is to accept the one with the shortest payback
time.
Advantages

Simple to compute -The first is its simplicity.


years taken recover the investment.

Provides some information on the risk of the investment


Provides a crude measure of liquidity

It effortlessly tells us the number of

Disadvantages

No concrete decision criteria to indicate whether an investment increases the firm's


value

Ignores cash flows beyond the payback period

Ignores the time value of money


Ignores the risk of future cash flows

Discounted Payback Period


The discounted payback period method accounts for the time value of money. In other
words, it allows us to discount the future cash inflows (or outflows) and calculate the
present the value of them.
Advantages

Considers the time value of money


Considers the riskiness of the project's cash flows (through the cost of capital)

Disadvantages

No concrete decision criteria that indicate whether the investment increases the
firm's value

Requires an estimate of the cost of capital in order to calculate the payback


Ignores cash flows beyond the discounted payback period

Net Present Value


Net present value, or NPV, is one of the calculations business managers use to evaluate
capital projects. A capital project is a long-term investment or improvement, such as
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building a new store. The NPV calculation determines the present value of the project's
projected future income.
Advantages

Tells whether the investment will increase the firm's value


Considers all the cash flows
Considers the time value of money
Considers the risk of future cash flows (through the cost of capital)

Disadvantages

Requires an estimate of the cost of capital in order to calculate the net present value.
Expressed in terms of dollars, not as a percentage.

Internal Rate of Return


The internal rate of return on an investment or project is the rate of return that makes
the net present value of all cash flows from a particular investment equal to zero. It can also
be defined as the discount rate at which the present value of all future cash flow is equal to
the initial investment or in other words the rate at which an investment breaks even.
Advantages

Tells whether an investment increases the firm's value


Considers all cash flows of the project
Considers the time value of money
Considers the risk of future cash flows (through the cost of capital in the decision
rule)

Disadvantages

Requires an estimate of the cost of capital in order to make a decision


May not give the value-maximizing decision when used to compare mutually
exclusive projects

May not give the value-maximizing decision when used to choose projects when
there is capital rationing

Cannot be used in situations in which the sign of the cash flows of a project change
more than once during the project's life

Modified Internal Rate of Return


The internal rate of return (IRR) assumes the cash flows from a project are reinvested
at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's
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cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore,
MIRR more accurately reflects the cost and profitability of a project.
Advantages

Tells whether an investment increases the firm's value


Considers all cash flows of the project
Considers the time value of money
Considers the riskiness of future cash flows (through the cost of capital in the
decision rule)

Disadvantages

Requires an estimate of the cost of capital in order to make a decision


May not give the value-maximizing decision when used to compare mutually
exclusive projects

May not give the value-maximizing decision when used to choose projects when
there is capital rationing

3) Please comment on the relation between accounting information quality and cost of
capital. Support your view with existing literature and research when necessary. (20 marks)
The link between accounting information and the cost of capital of firms is one of the most
fundamental issues in accounting. The past researcher argue that quality of accounting
information can reduce the cost of capital, many ways for examples higher quality
disclosures reduce the firms assessed covariance with other firms cash flows, which is
non-diversifiable and higher quality disclosures affect a firms real decisions, which likely
changes the firms ratio of the expected future cash flows to the covariance of these cash
flows with the sum of all the cash flows in the market. Arthur Levitt (1998), suggests that
high quality accounting standards reduce capital costs. Similarly, Neel Foster (2003),
claims that More information always equates to less uncertainty and people pay more for
certainty. Apergis and all find that, increase in expected cash flows, coming from
improvements in the quality of accounting information, leads to a reduction in the firms
cost of capital. Therefore, good quality financial information, the end result is that lower
cost of capital. The accounting information influences a firms cost of capital in two ways,
such as direct effects where higher quality accounting information does not affect cash
flows, but affects the market participants assessments of the distribution of future cash
flows and indirect effects where higher quality accounting information affects a firms
real decisions, which influences its expected value and covariance of firm cash flows.
The better information reduces the amount of firm cash flows that managers appropriate for
themselves, the improvements in disclosure not only increase price, but in general also
reduce firms cost of capital. Second, information quality change a firms real decisions,
e.g., with respect to production or investment. In this case, information quality changes the
ratio of expected cash flow to non-diversifiable covariance risk and hence influences a
firms cost of capital.

4) What is agency theory? Explain how corporate governance and other mechanisms can be
arranged to reduce agency cost
The relationship between principals and agents in business was created the agency theory.
Agency theory is concerned with resolving problems that can exist in agency relationships;
that is, between principals (such as shareholders) and agents of the principals (such as firm
management). The agency theory indicate two main problem such as the problems that arise
when the desires or goals of the principal (shareholders) and agent (management) are in
conflict, and the principal is unable to verify what the agent is actually doing; and the
problems that arise when the principal and agent have different attitudes towards risk.
Because of different risk tolerances, the principal and agent may each be inclined to take
different actions. Agency costs arise from the misalignment of the interests of the owners and
managers of firms when the separation of ownership and control occurs (Jensen, 1986). The
researchers identify a number of governance mechanisms which relate the interests of agents
and principals and so minimize agency costs. Coles, Daniel, and Naveen (2008) and Boone,
Field, Karpoff, and Raheja (2007) argued that firms adopted a range of governance
mechanisms, each of which is consistent with maximizing firm value and which will lead to
reduce the agency cost by increasing shareholder wealth through maximizing firm value .
Opler and Titman (1993) argued that firms that have high growth prospects are more likely to
be better managed. They are also less likely to have excess free cash flows because the
available cash will be spent on positive net present value projects which mean firm with high
growth performance are more likely to be better manage firm will lead to reduce the agency
cost by optimizing the cash flows. Thus, as Doukas, Kim, and Pantzalis (2000) argued,
agency costs may be regarded as a function of the interaction of growth opportunities and
free cash flow. Firms that combine low growth prospects and high free cash flow can
therefore be regarded as suffering from high agency costs; it required better governance
mechanisms to reduce the agency cost. Board governance mechanisms have been the focus
of a number of firms in order to reduce the agency cost such as boards should consist of a
balance of executive and non-executive directors. This suggests that existing board
structures represent an optimal outcome given the costs and benefits associated with
different types of director. Number of research support the view that non-executive directors
have a positive effect and find that boards dominated by non-executive directors are more
likely to act in shareholders best interests. Another good governance mechanism is the
separation of the posts of CEO and chairman because it gives one person to less power
potentially over the decision-making process will lead to minimize the agency costs by
diversify power over the one person.

5) What factors should be considered when making the decision on dividend policy?
There are many factors that influence the dividend decisions, those are as follows

Growth and Profitability


Liquidity- Cash Balance
Cost and Availability of Alternative Forms of financing- Need for additional Capital
Managerial Control
Legal constraints

Inflation
Type of Industry
Age of Corporation
Business Cycles
Taxation policy
Future Requirements

Growth and Profitability


The growth rate of the firm will influence to dividend decision of an organization. Firm with
high growth prospects maintain low payout ratio because of greater number of profitable
investment opportunities result capital needs which result the future expectation.
Liquidity:
The liquidity position or cash balance of a firm is an important consideration in dividend
decisions. Because dividends is usually represent a cash outflow to the firm, which result
that the better the cash position or better liquidity position of the firm is greater ability to pay
a cash dividend. Likewise when firm lack of cash or lack of liquidity, the firm ability pay
dividend is abolish.
Cost and Availability of Alternative Forms of financing- Need for additional Capital
The firms ability to raise money will have a direct impact on the level of dividends paid to
shareholders. If a firm has access to the capital market, and firm can conveniently and
economically get additional funds requirement in a number of alternative ways, will have
impact on dividend decision. The key question is whether or not a firm can (if the need
arises) finance its dividend payments externally. Those that can are likely to set higher
dividend levels than those that cannot.
Managerial Control

The control of the firm is a factor to consider when taking dividend decision. Because, many
substantial proportion of the firm is owned by a controlling group, and the remaining of the
stock is outside. Under this situation, the higher the payout ratio, the more likely that a
subsequent issue of equity may be needed to finance capital expenditures. Those in control
might prefer to minimize the offering of equity to avoid any dilution in their ownership
position; hence, they would prefer a low payout policy. On the other hand, a firm may
establish a relatively high dividend payout ratio as a way to keep the firm from being
acquired in a merger or acquisition.
Legal constraints
The rules and regulation very importance to firm and maybe act as barriers within the firm
for distribute the dividends. In general legal requirement is cash dividends must be paid from
current earnings or from previous earnings that have been retained by the firm rather than
cash raised from other source.
Inflation
Inflation must be taken into account when a firm taking a dividend decision. The investors
more like to receive larger cash dividends because of inflation. But from the firms
viewpoint, inflation causes it to have to invest substantially more to replace existing
equipment, finance new capital expenditures, and meet permanent working capital needs.
Thus, in inflationary times, there may be a tendency to hold down cash dividends.
Type of Industry:
Industries that are characterized by stability of earnings may formulate a more consistent
policy as to dividends than those having an uneven flow of income. For example, public
utilities concerns are in a much better position to adopt a relatively fixed dividend rate than
the industrial concerns.
Age of Corporation:
Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can
formulate clear cut dividend policies and may even be liberal in the distribution of dividends.
Business Cycles

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During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for
marketing the securities in an otherwise depressed market.
Taxation policy
Corporate income taxes affect dividends directly and indirectly directly, in as much as
they reduce the residual profits after tax available for shareholders and indirectly, as the
distribution of dividends beyond a certain limit is itself subject to tax
Future Requirements
Accumulation of profits becomes necessary to provide against contingencies (or hazards) of
the business, to finance future- expansion of the business and to modernize or replace
equipments of the enterprise.

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