Financial management

Activities – solutions and discussion

L. Fung
AC3059
2016

Undergraduate study in
Economics, Management,
Finance and the Social Sciences
These solutions were prepared for the University of London International Programmes by:
Dr L. Fung, Lecturer in Accounting and Finance, Birkbeck, School of Business, Economics and
Informatics
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AC 3059 Financial Management

Activities – solutions and discussion

Activity 1.1

Small companies are perceived to be at a higher risk as they are normally facing
higher chances of failure in their operations. Specific risks to a small company
are:

• Credit risk – higher cost of borrowing.

• Financial risk – lack of working capital and operating cash flows.
• Operational risk – failed business model.

Activity 1.2

The return from the capital market represents the lowest achievable return an
investor can obtain. Therefore a rational investor will invest in alternative
financial investments up to the point where the marginal investment equals the
return from the capital market.

If the borrowing rate and the lending rate are different, the Fisher’s separation
theorem breaks down. Consequently, Individual 1 and 2 in Figure 1.2 might not
be able to borrow or lend at a favourable rate to improve their consumption
patterns. Therefore a firm’s fixed dividend policy (regardless of investors’
preference) might not lend to an optimal solution.

Activity 1.3

Political stability, economic climate and labour markets are factors which are not
controlled by corporations. The ability to assess long-term plans very much
depends on the stability of market conditions.

Activity 1.4

Refer to BMA Chapter 1, pp.40–43.

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 Solutions and discussion

Activity 2.1

a.

Projects Payback period

(years)
A 3
B 2
C 3

b. You would only accept project B as the other projects have a longer
payback period than the cut-off period.

c. All three projects would be accepted.

d.

Projects Years NPV

A 0 1 2 3 4
CFS (5,000) 1000 1000 3000 0
DF 1 0.909 0.826 0.751 0.683
PV (5,000) 909 826 2253 0 (1,012)
Years
B 0 1 2 3 4
CFS (1,000) 0 1000 2000 3000
DF 1 0.909 0.826 0.751 0.683
PV (1,000) 0 826 1502 2049 3377
Years
C 0 1 2 3 4
CFS (5,000) 1000 1000 3000 5000
DF 1 0.909 0.826 0.751 0.683
PV (5,000) 909 826 2253 3415 2403

Projects B and C have positive NPVs.

e. Payback period favours those projects with higher cash flows at the
beginning of their lives. One might argue that short-lived projects tend to
have higher and more cash flows upfront which will be more susceptible
when using the payback period.

f. If a firm uses the discounted-payback rule, it is unlikely that any negative-

NPV projects will be accepted. We can see from the table above that
project A’s discounted cumulative cash flows will always be negative in its
life time. It suggests that negative-NPV projects will never payback based
on their discounted cash flows.

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59 Financial management

On the other hand, the discounted payback period for Project B is 2 +

(1,000 – 826)/1502 years and for Project C is 3 + (5,000 – 909 – 826 –
2,253)/3,415 years. If the cut-off period is set at 3 years, Project C will
not be accepted. Therefore it is likely that positive-NPV projects might be
turned down using the discounted payback rule.

Activity 2.2

a. Two

b. -50% and +50%

c. Yes, NPV = +14.6

Activity 2.3

Prove that an asset that generates $C each year for n years has a present value
= C/r – C/[r(1 + r)n].

The present value of a constant $C for n years is

The present value of a constant cash flow, C, for n periods is:

(1) P = C/(1 + r) + … + C/(1 + r)n

Define the discount factor:

(2) a = 1/(1 + r)

Substituting a into the formula, we get:

(3) P = C x [a + a2 + …. an]

Multiply both sides of equation (3) by a, we get:

(4) aP = C x [a2 + …. an+1]

Subtracting equation (4) from equation (3) we get:

(5) (1 – a)P = C x [a – an+1]

Note that 1 – a = r/(1 + r) and a – an+1 = 1/(1 + r)[1 – 1/(1 + r)n] by replacing
a with the discount factor 1/(1 + r). Therefore equation (5) is reduced to:

(6) rP/(1 + r) = C/(1 + r) )[1 – 1/(1 + r)n]

Multiply both side of equation (60 by (1 + r)/r, we get the expression

Activity 3.1

Projects 1, 2, 4, and 6. This will generate the highest weighted average PI.

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 Solutions and discussion

Activity 3.2

The IRR is the discount rate which, when applied to a project’s cash flows, yields
NPV = 0. Thus, it does not represent an opportunity cost. However, if each
project’s cash flows could be invested at that project’s IRR, then the NPV of each
project would be zero because the IRR would then be the opportunity cost of
capital for each project. The discount rate used in an NPV calculation is the
opportunity cost of capital. Therefore, it is true that the NPV rule does assume
that cash flows are reinvested at the opportunity cost of capital.

Activity 5.1

Ms. Sauros had a slightly higher average return (14.6% vs. 14.4% for the
market). However, the fund also had a higher standard deviation (13.6% vs.
9.4% for the market).

Activity 5.2

Activity 5.3

10 A

P = -1

P=0
P=1

P = -1

5
B

Risk

5 10

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59 Financial management

Activity 6.1

In reality, the borrowing rate is often higher than the lending rating for
individual investors. The Two Fund Separation Theorem breaks down. See the
diagram below.

E(R)

Standard Deviation

Activity 6.2

a. See Figure 3 below

b. A, D, G

c. F

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 Solutions and discussion

d. 15% in C

e. Put 25/32 of your money in F and lend 7/32 at 12%: Expected return =
7/32 × 12 + 25/32 × 18 = 16.7%; standard deviation = 7/32 × 0 +
(25/32) × 32 = 25%. If you could borrow without limit, you would achieve
as high an expected return as you’d like, with correspondingly high risk, of
course.

Activity 6.3

Small investors might not have sufficient funds to diversify their portfolios (as
Figure 3.4 shows an effective diversification may require investing in at least 15
different stocks). In this case, it would be sensible for them to invest in mutual
funds or unit trusts which are arguably diversified portfolios managed by fund
managers.

Activity 6.4

Consider the following factor model:

R = rf + b1 x change in GNP + b2 x change in energy prices + b3 x change in

long-term interest rate + e

a. Uncorrelation with the three factors means that b1, b2 and b3 are zero. The
expected return of this stock is therefore 7% as in the case of the risk-free

b. 7 + 1(5) + 1(–1) + 1(2) = 13%

c. 7 + 0(5) + 2(–1) + 0(2) = 5%

d. 7 + 1(5) + (–1.5)(–1) + 1(2) = 15.5%

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59 Financial management

Activity 7.1

a.

Expected return

0 0.5 1 1.5 2
Beta

b. Market risk premium = rm – rf = 0.12 – 0.04 = 0.08 = 8.0%

c. Use the security market line:

r = rf + β(rm – rf)
r = 0.04 + [1.5 × (0.12 – 0.04)] = 0.16 = 16.0%

d. For any investment, we can find the opportunity cost of capital using the
security market line. With β = 0.8, the opportunity cost of capital is:
r = rf + β(rm – rf)
r = 0.04 + [0.8 × (0.12 – 0.04)] = 0.104 = 10.4%
The opportunity cost of capital is 10.4% and the investment is expected to
earn 9.8%. Therefore, the investment has a negative NPV.

e. Again, we use the security market line:

r = rf + β(rm – rf)
0.112 = 0.04 + β(0.12 – 0.04) ⇒ β = 0.9

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 Solutions and discussion

Activity 7.2

RBoeing = 0.2% + (0.66 × 7%) + (01.19 × 3.6%) + (–0.76 × 5.2%) = 5.152%

RJ&J = 0.2% + (0.54 × 7%) + (–0.58 × 3.6%) + (0.19 × 5.2%) = 2.88%
RDow = 0.2% + (1.05 × 7%) + (–0.15 × 3.6%) + (0.77 × 5.2%) = 11.014%
RMsft= 0.2% + (0.91 × 7%) + (–0.04 × 3.6%) + (–0.4 × 5.2%) = 4.346%

Activity 8.1

In most cases you should find that the Monday’s price is higher or lower than the
predicted Monday’s price.

Activity 8.2

i. A systematic price pattern appears. This might suggest that the weak
form of efficiency is violated. However, if the price difference in December
and January is not significant, investors might still not be able to earn
abnormal returns after transaction costs. If this is the case, then the
market is still informationally efficient in its weak form.

ii. If these stocks are of the same level of risk and small stocks are
consistently out-performing the large stocks, then this systematic pricing
pattern may allow investors to obtain abnormal gains. Therefore the weak
form efficiency might be violated. However, if these stocks were of
different risk levels, then the evidence here would not be conclusive
against market efficiency.

iii. If the report’s findings are conclusive, then the evidence seems to suggest
that insider trading is not possible. Therefore there is no evidence against
the strong form efficiency. However, if insider trading was simply not
detected by the Stock Exchange, and some insiders are making abnormal
gains based on their private information, then the strong form efficiency
would be violated.

iv. In this case the share price moves upon an arrival of information. It
seems to suggest that the market is consistent with the semi-strong form.
However, BAC’s share price falls despite a record profit. It might suggest
that the market is anticipating a much higher reported profit. This
expectation has already been built in the share price. So when the
announcement is made and the reported profit does not meet the
market’s expectation, the share price falls accordingly.

v. If Mrs Smith is true about her trading method, then the evidence in this
case seems to be contradicting market efficiency. However if she is lying
about her success, then there is no evidence to suggest the violation of
market efficiency.

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59 Financial management

Activity 8.3

You should revise the materials covered on pp.358–61 of BMA.

Activity 9.1

As mentioned in the Subject Guide, a company seeks a quotation on a stock

exchange to raise funds, increase profile and facilitate future access to equity
and take-over.

The fact the share price of Essar Energy fell after the IPO may indicate that the
initial offer price was an over-estimate. As the company was exposed to the
public, analysts revised their forecast and downgraded the share value of the
company.

Activity 9.2

Refer to the Subject Guide, pp.64 ‘Flotation’.

Activity 9.3

Refer to the Subject Guide, pp.65 ‘Why do companies seek listing on more than
one stock exchange?’

Activity 10.1
With reference to the advantages and disadvantages of public offers of shares,
discussed in Chapter 9, consider the advantages and disadvantages of public
offers of bonds.

Advantages for public offer of bonds:

• reaching more investors and hence there is a higher chance for full
subscription
• bonds are traded in the market and hence increases the liquidity of
the issued bonds.

Disadvantages for public offer of bonds:

• more documents to be prepared before bond issues

• restriction from the relevant market authority
• approval for investors may be required in some countries for bond
issued in the public.

Activity 10.2
Apart from the conditions listed above, can you think of any other factors that a
corporation should consider before issuing any debt? In Chapters 11 and 12 we
will discuss some of the leading capital structure theories. You may identify that
apart from those factors listed in Chapter 10 of the subject guide, the other
factors may be those in Table 12.1.

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 Solutions and discussion

Activity 11.1

Expected return on assets is rA = 0.08 × 30/80 + 0.16 × 50/80 = 0.13. The new
return on equity will be rE = 0.13 + (20/60)(0.13 – 0.08) = 0.147.

Activity 11.2

1. Company A may adhere to a high debt policy to take advantage of the

potentially high tax shield benefits.

2. Company B may have stable future cash flows and therefore would be
faced with a lower potential cost of financial distress. According to the
trade-off theory, this company may afford a higher level of debt financing.

3. Company C’s earnings may initially be volatile. The potential rate of failure
for a new start-up company may also be high. Therefore it is unlikely that
it can adhere to a high level of debt.

Activity 11.3

If the tax rate for both income from dividends and capital gains is the same,
then the tax shield effect in equation 6.7 will be reduced to TcD. What this
means is that in this case, companies will be faced with a situation similar to
MM’s argument in the world with corporate tax only, suggesting that firms
should use debt financing as much as possible.

Activity 11.4

1. High capital investment activity implies a high tax shield substitute.

Therefore this national utility company is unlikely to adhere to high level
of debt.

2. The oil depletion allowance for such an oil exploration company might be
high and therefore the level of debt is likely to be low.

3. A substantial part of the research and development expenditures might

qualify for tax deduction. This increases the level of other tax substitutes
and therefore the advantage of the tax shield effect from debt will be
diminished.

Activity 11.5

Answers here will vary according to the companies chosen; however, the
important considerations are given in the text, Section 19.3.

Activity 11.6

More profitable firms have more taxable income to shield and are less likely to
incur the costs of distress. Therefore the trade-off theory predicts high (book)
debt ratios. In practice the more profitable companies borrow least.

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59 Financial management

Activity 12.1

In practice, incentive scheme payment may be recalled within a suitable period

beyond period 1 (as in the sample) if managers fail to sustain the value they
claim to have produced for the company. Those who are found guilty of cheating
the market might also be subject to additional financial losses and risk
imprisonment.

Activity 12.2

This is the main problem with the agency costs on equity and debt. As these
direct and indirect costs of sub-optimal agents’ action are difficult to measure,
the practicality of this theory in real life is limited.

Activity 13.1

Advantages Disadvantages
Open market Easy to repurchase Does not facilitate large
stocks via the stock quantity of stock
market. repurchase (to avoid
price-manipulation).

Tender offer Repurchasing firms know There might be a risk of

exactly the amount to under-subscription.
pay to buy back their
shares.

Auction Allow repurchasing firms The lowest price might

to set the lowest offer still be too high for the
price based on the bids repurchasing firms to sell
submitted by all the intended shares.
shareholders.

Private negotiation Specific deal can be done Likely to pay a higher

with direct negotiation premium to secure the
with a major deal.
shareholder.

Activity 13.2

The tax clientele effect indicates that investors would choose a firm with the
appropriate dividend payout policy to reduce their tax liabilities. If the tax rate
on dividend income and capital gains is identical, it does seem that the different
payout policies would not affect the investors’ tax position. Tax clientele effect
does not seem to be applicable in this case.

Activity 13.3

1. The announcement of an increase in dividend and the proposed

repurchase of stock seemed to drive Vodafone’s share price up on 18
November 2003.

11
 Solutions and discussion

2. Share repurchase is often regarded as a form of dividend payout. The fact

that Vodafone was going to repurchase shares from existing shareholders
seemed to suggest that the company’s operating cash flow was healthy
and the spare cash used up to repurchase shares was being put to good
use (refer to the agency costs of dividend on p.88 of the Subject Guide).

3. According to Lintner’s stylised facts, an increase in dividend is often seen

as a show of confidence by corporate managers regarding the company’s
future cash flows.

Activity 13.4

When the market is not informationally efficient, a firm’s true quality may not be
observable. In this case, there is a strong argument for more information about
the firm’s operations to be released on a regular basis.

Activity 14.1

Recall in Example 8.1, the risk-adjusted discount rate for projects A, B and C are
8%, 9% and 11% respectively. Consequently, if the weighted average cost of
capital of 9.3% is used, then the NPV of Projects A and B will be under-
estimated whereas the NPV of Project C is will be over-estimated.

Activity 14.2

Using the CAPM and the estimated beta for Grand plc, the expected return on
Grand plc is

E(R) = 5 + 0.8 x (10 – 5) = 9% (using the data from Big plc)

Or
E(R) = 5 + 0.77 x (10 – 5) = 8.85% (using the data from Large plc)

Activity 15.1

The key difference between the asset based valuation of a company such as
Coca Cola and its market capitalisation is that the financial statements do not
recognise ALL assets employed by the company. Internally generated goodwill
and brand name are often not treated as recognisable assets on the financial
statements. However the stock market valuation take those into consideration.

Activity 15.2

The value of the debt = 10 x A5, 5% + 100 x DF5, 5% = 10 x 4.33 + 100 x 0.784 =
121.6

Activity 16.1

1. a. Horizontal
b. Conglomerate
c. Vertical
d. Conglomerate.

2. a and d; c can also make sense, although merging is not the only way to
redeploy excess cash.

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59 Financial management

Activity 16.2
The answer to this activity question depends on the mergers you are analysing.
In general, firms fund their mergers with a variety of methods – as outlined on
pp.113 and 114 of the Subject Guide.

Activity 16.3

a. Use the perpetual growth model of stock valuation to find the appropriate
discount rate (r) for the common stock of Plastitoys (Company B):

0.80
= 20 ⇒ r = 0 .10 = 10.0%
r − 0 .06

Under new management, the value of the combination (AB) would be the
value of Leisure Products (Company A) before the merger (because
Company A’s value is unchanged by the merger) plus the value of
Plastitoys after the merger, or:

 $0.80 
PVAB = (1,000,000 × $90) + 600,000 ×   = $114,000,0 00
 0.10 − 0 .08 

We now calculate the gain from the acquisition:

Gain = PVAB − (PVA + PVB )
Gain = $114,000,0 00 − ($90,000,0 00 + $12,000,00 0) = $12,000,00 0

b. Because this is a cash acquisition:

Cost = Cash Paid – PVB = ($25 × 600,000) – $12,000,000 = $3,000,000

c. Because this acquisition is financed with stock, we have to take into

consideration the effect of the merger on the stock price of Leisure
Products. After the merger, there will be 1,200,000 shares outstanding.
Hence, the share price will be:
$114,000,000/1,200,000 = $95.00
Therefore:
Cost = ($95 × 200,000) – ($20 × 600,000) = $7,000,000

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 Solutions and discussion

d. If the acquisition is for cash, the cost is the same as in Part (b), above:
Cost = $3,000,000
If the acquisition is for stock, the cost is different from that calculated in
Part (c). This is because the new growth rate affects the value of the
merged company. This, in turn, affects the stock price of the merged
company and, hence, the cost of the merger. It follows that:
PVAB = ($90 × 1,000,000) + ($20 × 600,000) = $102,000,000
The new share price will be:
$102,000,000/1,200,000 = $85.00
Therefore:
Cost = ($85 × 200,000) – ($20 × 600,000) = $5,000,000

Activity 17.1

Question 2

a. ROA = ((1 – 0.35) x 67 + 474)/4,126 = 0.125, or 12.5%

b. Operating profit margin = ((1 – 0.35) x 67 + 474)/7,911 = 0.065, or

6.5%

c. Sales-to-assets = 7,911/4,126 = 1.9

d. Inventory turnover = 1,997/856 = 2.3

e. Debt-to-equity ratio = 1,078/1,653 = 0.65

f. Current ratio = 2,787/1,699 = 1.64

g. Quick ratio = (402 + 1,034)/1,699 = 0.85

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59 Financial management

Question 3.

COMMON-SIZE BALANCE SHEET, 2008

% %
Cash & marketable 8.0 Debt due for repayment 2.4
securities
Accounts receivable 20.6 Accounts payable 31.6
Inventories 19.7 Total current 33.9
liabilities
Other current assets 7.2 Long-term debt 21.5
Total current assets 55.6 Other long-term 11.6
liabilities
Tangible fixed assets 47.8 Total liabilities 67.0
Less accumulated 27.0 Total shareholders’ 33.0
depreciation equity
Net tangible fixed assets 20.8
Long-term investments .5
Other long-term assets 23.1
Total assets 100 Total liabilities & 100
shareholders’ equity

COMMON-SIZE INCOME STATEMENT, 2008

Sales 100%
Cost of goods sold 25.2
Selling, general and 61.3
administrative expenses
Depreciation 3.2
Earnings before interest & 10.3
taxes
Interest expense .9
Taxable income 9.4
Tax 3.3
Net income 6.0

Question 4.

a. Market-value-added = 195 x $45.50 – $1,653 = $7,220 million

b. Market-to-book = 195 x $45.50/$1,653 = 5.4

c. EVA = [(1 – 0.35) x 67 +474] – [0.10 x (1,078 + 1,653)] = $177.7

million

d. ROC = [(1 – 0.35) x 67 +474]/(1,078 + 1,653) = 0.190, or 19.0%

15
 Solutions and discussion

Activity 17.2

The ability to meet or beat the targets embodied in a financial plan is obviously a
reassuring signal of management talent and motivation. Moreover, the financial
plan focuses attention on the specific targets that top management deems most
important. There are, however, several dangers.
a. Financial plans are usually accounting-based, and thus, are subject to the
biases inherent in book profitability measures.
b. Managers may sacrifice the firm’s best long-term interests in order to
meet the plan’s short- or medium-run targets.
c. Manager A may make all the right decisions, but fail to meet the plan
because of events beyond his control. Manager B may make the wrong
decisions, but be rescued by good luck. In other words, it may be difficult
to separate performance and ability from results.

Activity 17.3

a. Calculate the equivalent loan by discounting at the after-tax cost of debt,

6.5 × (1 − 0.32 ) = 4.42%. The equivalent-loan amount is SFr147,500.

b. The lease provides initial financing of SFr150,000, so the lease’s NPV =

+SFr2,500.

c. Even with the lease, the conveyer’s NPV is negative. Do not invest or sign
the lease.

Activity 18.1

Just-in-time is a production strategy which aims to keep inventory at its

minimum level and reduce carrying costs. Build-to-order is also a production
approach which requires companies to only start production when orders are
confirmed. Both of these approaches require the supply of materials and labour
to work smoothly. Companies which exercise these approaches must ensure that
strikes, traffic snarl-ups, and any other production hazards do not interfere with
the flows of materials and labour.

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59 Financial management

Activity 18.2

Consider the NPV (per $100 of sales) for selling to each of the four groups:
Classification NPV per $100 Sales

100 × (1 − 0)
− 85 + = $13.29
1 1.15 45 / 365

100 × (1 − 0 .02)
− 85 + = $11.44
2 1.15 42 / 365

100 × (1 − 0 .10)
− 85 + = $ 3.63
3 1.15 40 / 365

100 × (1 − 0.20)
− 85 + = − $ 7.41
4 1.15 80 / 365

If customers can be classified without cost, then Velcro should sell only to
Groups 1, 2 and 3. The exception would be if non-defaulting Group 4 accounts
subsequently became regular and reliable customers (i.e., members of Group
1, 2 or 3). In that case, extending credit to new Group 4 customers might be
profitable, depending on the probability of repeat business.
Activity 19.1

Insurance companies have the experience to assess routine risks and to advise
companies on how to reduce the frequency of losses. Insurance company
experience and the very competitive nature of the insurance industry result in
correct pricing of routine risks. However, BP, for example, has concluded that
insurance industry pricing of coverage for large potential losses is not efficient
because of the industry’s lack of experience with such losses. Consequently, BP
has chosen to self-insure against these large potential losses. Effectively, this
means that BP uses the stock market, rather than insurance companies, as its
vehicle for insuring against large losses. In other words, large losses result in
reductions in the value of BP’s stock. The stock market can be an efficient risk-
absorber for these large but diversifiable risks.

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 Solutions and discussion

Activity 19.2

Option 1 Option 2

Pay-off ($) Pay-off ($)

Share price Share price

45 50

Activity 19.3

Statement (b) is correct. The appropriate diagrams are in Figure 20.6 in the
text. The first row of diagrams in Figure 20.6 shows the payoffs for the strategy:

Buy a share of stock and buy a put.

The second row of Figure 20.6 shows the payoffs for the strategy:

Buy a call and lend an amount equal to the exercise price.

Activity 19.4

a. P = 200 EX = 180 σ = 0.223 t = 1.0 rf = 0.21

d1 = log[P/PV(EX)]/σ t + σ t /2
= log[200/(180/1.21)]/(0.223 × 1.0 ) + (0.223 × 1.0 ) /2 = 1.4388
d2 = d1 − σ t = 1.4388 − (0.223 × 1.0 ) = 1.2158
N(d1) = N(1.4388) = 0.9249
N(d2) = N(1.2158) = 0.8880
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.9249 × 200] – [0.8880 × (180/1.21)] = $52.88

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59 Financial management

b.

1 + upside change = u = eσ h
= e0.223 1.0
= 1.2498
1 + downside change = d = 1/u = 1/1.2498 = 0.8001
Let p equal the probability that the stock price will rise. Then, for a
risk-neutral investor:
(p × 0.25) + (1 – p) × (–0.20) = 0.21
p = 0.91
In one year, the stock price will be either $250 or $160, and the
option values will be $70 or $0, respectively. Therefore, the
value of the option is:

(0.91× 7 0) + (0.09 × 0)
= $52 .64
1.21
c.
1 + upside change = u = eσ h = e0.223 0.5 = 1.1708
1 + downside change = d = 1/u = 1/1.1708 = 0.8541
Let p equal the probability that the stock price will rise. Then, for a
risk-neutral investor:
(p × 0.171) + (1 – p) × (–0.146) = 0.10
p = 0.776

Activity 19.5

F = S(1 + rf + sc – cy). Therefore 2,408 = 2,550(1.12 + 100/2,550 – cy) and cy

= 548/2,550 = 0.215, or 21.5%.

Activity 19.6

The amount to be borrowed depends on the interest rate on the $ loan. Suppose
the three months interest rate is 3%. The amount to be borrowed now would be
$100,000/1.03 = $97,087

19