Prepare a statement showing the incremental cash flows
1. Analyse fundamental corporate finance decisions and discuss their applications.
2. Apply the investment decision rules of the traditional and discounted cash flow methods in analysing investment decisions and discussing the outputs, while utilising the outputs for investment decisions.
3. Be able to compute cost of capital; discuss and critically evaluate working capital policies and apply cash management models in analysing business working capital policies.
4. Understand the capital structure and the Weighed Average cost of capital as a source of value creation for the Shareholder.
Question 1
Riphean plc and Silurian plc are two businesses operating in different industries from one another. They are both financed by a mixture of ordinary share and loan capital and both are seeking to derive the cost of capital for investment decision making purposes. The following information is available concerning the two businesses for the year to 30 November Year 8:
Riphean plc Silurian plc
Profit for the year £3.0m £4.0m
Gross dividends £1 .5m £2.0m
Market value per ordinary share £4.00 £1 .60
Number of ordinary shares 5m 1 0m
Gross interest yield on loan capital 8% 1 2%
Market value of loan capital £10m £16m
The annual growth rate in dividends is 5 per cent for Riphean plc and 8 per cent for Silurian plc.
Assume a 30 per cent tax rate.
Required:
(a) Calculate the weighted average cost of capital of Riphean plc and Silurian plc using the information provided.
(b) Discuss two possible reasons why the cost of ordinary share capital differs between the two businesses.
(c) Discuss two limitations of using the weighted average cost of capital when making invest- ment decisions.
Question 2
Company Eclectic Ltd produces a range of central heating systems for sale to builder’s merchants. As a result of increasing demand for the business products, the Directors have decided to expand production. The cost of acquiring the new plant and machinery and the increase in working capital requirements are planned to be financed by a mixture of long-term and short-term borrowing. The greater the level of depth in your answer, the higher the number of marks given.
Required:
a) Discuss the major factors that should be taken into account when deciding on the appropriate mix of long-term and short-term necessary to finance the expansion programme.
b) Discuss the major factors that a lender should take into account when deciding whether to grant a long-term loan to the business.
c) Identify three conditions that might be included in a long-term loan agreement and state the purpose of each.
Question 3
Viva Mills is considering expanding its production to a new yarn. The plant is expected to cost £1 million and have a life over five years and a nil residual value. It will be bought, paid and ready for operation on December 31st Year 0. £500,000 has already been spent on development costs of the product and this has been charged in the income statement the year it was incurred.
The following results are projected for the yarn:
Year 1 Year 2
Year 3
Year 4
Year 5
Sales revenue
1.2
1.4
1.4
1.4
1.4
Costs, including depreciation
-1
-1.1
-1.1
-1.1
-1.1
Profit before tax
0.2
0.3
0.3
0.3
0.3
Tax is charged at 50% on annual profits (before tax and after depreciation) and paid one year in arrears. Depreciation of the plant has been calculated on a straight-line basis. Additional working capital of £600,000 will be required at the beginning of the project and released at the end of year 5. You should assume that all cash flows occur at the end of the year in which they arise.
Required:
a) Prepare a statement showing the incremental cash flows of the project relevant to a decision concerning whether or not to proceed with the construction of the new plant.
b) Compute the net present value (NPV) of the project using a 10% discount rate.
c) Compute the payback period to the nearest year. Explain the meaning of this term.
Question 4
Write a 2000-word report explaining:
1. The validity of the CAPM formula including main advantages and drawbacks for Beta.
2. Include examples of companies with high and low betas and high/low levels of risk. Mention at least one company with high risk but low Beta and explain why this happens.
3. Relate the above with the concepts of volatility and correlation. Use the formula of Beta if appropriate.
4. Relate the above with the Black Scholes model and the use of options to predict volatility.
5. Mention the current ERP in the United States or in another developed country of your choice. It is mandatory to use valuable sources (don’t use Wikipedia) and its relationship with the time of study.
6. Comment on he importance of choosing the right risk free rate in terms of maturity and reasons why this is important.
7. Give a recommendation of which cost of equity formula to use. Justify your answer.
