Questions and Answers of Corporate Financial Management

=+Why do analysts obtain historic information on a company for valuation purposes?
=+1===+In what circum-stances is it particularly useful?2
=+1 What are the problems of relying on NAV as a valuation method?
=+use valuation models to estimate the value of shares when managerial control is achieved.
=+demonstrate awareness of the most important input factors and appreciate that they are difficult to quantify;
=+describe the principal determinants of share prices and be able to estimate share value using a variety of approaches;
=+Explain those areas where you have made difficult judgements in deciding which numbers to use.
=+c Given the difficulties in the calculation of WACC are companies justified in using using rules of thumb rather than theoretically precise methods? Explain the diffi-culties and describe the
=+b Comment on the appropriateness of using this technique for estimating the cost of capital for project appraisal purposes for a company with many subsidiaries in dif-ferent markets.
=+Create an estimate of the weighted average cost of capital (WACC).
=+The market value of the firm's equity is twice the value of its debt.The cost of borrowed money to the company is estimated at 12 per cent (before tax shield benefits).-Corporation tax is 30 per
=+The latest annual dividend has just been declared at 32p per share and the com-pany's market share price is 310p.
=+The finance department has assembled the following information:The company has an equity beta of 1.50, which may be taken as the appropriate adjustment to the average risk premium. The yield on
=+3 (Examination level) Diversified ple is trying to introduce an improved method of assessing investment projects using discounted cash flow techniques. For this it has to obtain a cost of capital
=+operating profit margin and the number of years in the planning horizon. Show a table containing alternative profit margin assumptions and planning horizon assumptions.
=+Conduct sensitivity analysis on the calculated shareholder value by altering the
=+Calculate shareholder value using Rappaport's method.
=+b Calculate the cost of equity finance.
=+The rate of return available by purchasing long-term government securities is cur-rently 6 per cent and the average risk premium for shares over the risk-free rate has averaged 5 per cent. Petalt's
=+3 Equity capital with a market value of £2m.
=+2 A 25-year vanilla bond issued 20 years ago at par (£100) raising £1m. The bond has an annual coupon of 5 per cent and is currently trading at £80. The next coupon is due in one year.
=+1 A floating-rate bank loan for f1m at 2 per cent over bank base rate. Base rates are currently 9 per cent.
=+2 (Examination level) Petalt plc wishes to carry out a shareholder value analysis for which it has gathered the information shown in the table opposite:The managers do not yet know the cost of
=+d Should Burgundy use the WACC for all future projects and SBUs? Explain your answer.
=+Calculate the weighted average cost of capital.
=+b Calculate the cost of equity capital.
=+by the co-movement of its shares and the market index correctly reflects the risk adjust-ment necessary to the average risk premium - this is 0.85. The corporate tax rate is 30 per cent. Burgundy
=+The company's shares have a market value of £4m, the return on risk-free government securities is 8 per cent and the risk premium for an average-risk share has been 5 per cent. Burgundy's shares
=+1. (Examination level) Burgundy ple is financed through bonds and ordinary shares. The bonds were issued five years ago at a par value of £100 (total funds raised £5m). They carry an annual
=+6 Explain two of the practical difficulties in calculating a firm's cost of capital.
=+5 Should the WACC be used in all circumstances?
=+4 Describe the weighted average cost of capital and explain why a project SBU or prod-uct line should not be evaluated using the cost of finance associated with the latest portion of capital raised.
=+2 Explain how you might calculate the cost of equity capital.
=+Visit www.pearsoned.co.uk/arnold for further questions, weblinks and an online glossary.
=+Write a report giving as full a picture of the project as possible.Comment on the quality of risk assessment for major investments within your firm.Provide implications and recommendations sections
=+Probability analysis (expected return, standard deviation, probabilities of various eventualities).
=+1 Gather together sufficient data on a recent or forthcoming investment in a firm you know well to be able to carry out the following forms of risk analysis:Sensitivity analysis.b Scenario
=+C If the project produces a net present value less than minus £1m the directors fear that the company will be vulnerable to bankruptcy. Calculate the probability of the firm avoiding bankruptcy.
=+b Calculate the standard deviation for the project.
=+The annual cash flows and marketing costs will be payable at each year end.Assume Cost of capital: 10 per cent.No inflation or taxation.-No exchange rate changes.Required Calculate the expected net
=+a 0.6 probability of sales immediately falling to 50,000 units per year.The plant and machinery will have no alternative use once installed and will have no scrap value:
=+a a 0.4 probability of maintaining the annual sales at 700,000 units; and b
=+The product is seen as a temporary fad and sales fall to 100,000 units for the remaining 10 years - probability 0.7.If success is achieved in only one country in the first year then for the
=+If the first year is a success in both countries then two possibilities are envisaged:a Sales levels are maintained at Im units per annum for the next 10 years - probability 0.3 b
=+If the marketing launch is unsuccessful in both countries, first year sales will be 200,000 umbrellas.The probability of each of these events occurring is:-1m sales: 0.3-0.7m sales: 0.4-0.2m sales:
=+The net cash flows before depreciation of plant and machinery and before market-ing expenditure for each umbrella will be £1.The products will be introduced both in the UK and in France.The
=+12" (Examination level) The UK manufacturer of footwear, Willow plc, is considering a major investment in a new product area, novelty umbrellas. It hopes that these prod-ucts will become fashion
=+The management wish you to calculate the probability of this product producing a negative net present value (assume a normal distribution). The appropriate discount rate for a project of this risk
=+d A change in the law now makes the outcome of Project D subject to risk because the cash flows depend upon the actions of central government. The project will still require an initial cash outflow
=+b Briefly explain two reasons why you might regard net present value as being supe-rior to internal rate of return for project appraisal.Now assume that at Time 0 only £700,000 of capital is
=+Assume that the annual cash flows arise on the anniversary dates of the initial outlay and that there is no inflation or tax.Required a Calculate the net present value for each of the projects on
=+The appropriate rate of discount is judged to be 10 per cent for risk-free projects.Accepting one of the projects does not exclude the possibility of accepting another one, and each can only be
=+11 (Examination level) Alder ple is considering four projects, for which the cash flows have been calculated as follows:Points in time (yearly intervals)Project 01 23 45 A-£500,000+£600,000
=+c If the NPV is greater than positive £100m then the share price of RJW will start to rise rapidly in two or three years after the purchase. What is the probability of this occurring?
=+b There is a chance that events will turn out to be much worse than RJW would like. If the net present value of the English operation turns out to be worse than negative£550m, RJW will be
=+a Calculate the expected net present value (NPV) and the standard deviation of the NPV for the project to buy the English lignite mines if £900m is taken to be the ini-tial cash outflow.
=+2 Cash flows will arise at year ends except the initial payment to the government which occurs at Time 0.Required
=+1 The cost of capital can be taken to be 14 per cent.
=+On the other hand, events may not turn out as well as RJW's estimates. There is a 20 per cent probability that the cash flows will be as shown in Table 3.Table 3: A more pessimistic scenario
=+You believe the probability of RJW's projections being correct to be 50 per cent (or 0.5). You also estimate that there is a chance that RJW's estimates are over-cautious.There is a 30 per cent
=+RJW's projections are as follows, excluding the cost of purchasing the mines:Table 1: Cash flows for the English lignite mines: RJW's estimate
=+b Calculate the standard deviation of NPV.10 (Examination level) RJW plc is a quoted firm which operates ten lignite mines in Wales. It has total assets of £50m and the value of its shares is
=+Calculate the expected NPV.
=+The risk-free rate of return is 8 per cent. There is no tax or inflation.
=+Assume that the state of the economy will be the same in the second year as in the first.
=+9 A project requires an immediate outflow of cash of £400,000 in return for the follow-ing probable cash flows:State of economy Probability End of Year 1 (f)End of Year 2 (E)Recession 0.3 100,000
=+8 A project with an initial outlay of Elm has a 0.2 probability of producing a return of£800,000 in Year 1 and a 0.8 probability of delivering a return of £500,000 in Year 1. If the £800,000
=+c The probability of the NPV being less than zero assuming a normal distribution of return - (bell shaped and symmetrical about the mean).d Interpret the figure calculated in (c).
=+The expected NPV.b The standard deviation of NPV.
=+The events in each year are independent of other years (that is, there are no conditional probabilities). An outlay of £15,000 is payable at Time 0 and the other cash flows are receivable at the
=+7(Examination level) Toughnut ple is considering a two-year project that has the following probability distribution of returns:Year 1 Year 2 Return Probability Return Probability 8,000 0.1 4,000
=+6 The returns from a project are normally distributed with a mean of £220,000 and a standard deviation of £160,000. If the project loses more than £80,000 the company will be made insolvent.
=+5 Project W may yield a return of £2m with a probability of 0.3, or a return of £4m with a probability of 0.7. Project X may earn a negative return of £2m with a probability of 0.3 or a positive
=+c Explain to the management team how this analysis can help to direct attention and further work to improve the likelihood of a successful project implementation.
=+b To gain a broader picture they also want you to recalculate IRR on the assumption that each of the following variables changes adversely by 5 per cent in turn:- sales volume;= sales
=+The senior management team have asked you to calculate the internal rate of return (IRR) of this project based on these estimates.
=+sales volume of 22,000 units per year;sales price £21 per unit;variable direct costs £16 per unit.There are no other costs and inflation and tax are not relevant.a
=+4 (Examination level) A company is trying to decide whether to make a £400,000 invest-ment in a new product area. The project will last 10 years and the £400,000 of machinery will have a zero
=+3" Use the data in question 2 to calculate the NPV in two alternative scenarios:Worst-case scenario Best-case scenario Sales volume 90,000 Sales volume 110,000 Sales price £1.90 Sales price £2.15
=+b For the four variables considered in (a) state the break-even point and the percent-age deviation from 'most likely' levels before break-even NPV is reached (assuming all other variables remain
=+The initial investment consists of £70,000 in machines, which have a zero scrap value at the end of the three-year life of the project and £20,000 in additional working capi-tal which is
=+2* (Examination level) Cashion International are considering a project that is susceptible to risk. An initial investment of £90,000 will be followed by three years with the fol-lowing 'most
=+Now examine the impact on NPV of raising the discount rate by the following risk premiums:a 3 percentage points;b 6 percentage points.
=+1 Calculate the NPV of the following project with a discount rate of 9 per cent.Point in time (yearly intervals)0 12 34 Cash flow (£000s)-800 300 250 400 500
=+10 What is the probability of an outcome being within 0.5 of a standard deviation from the expected outcome?
=+(a) the risk-free discount rate is used, (b) the risk-adjusted discount rate is used?
=+9 What does it mean if a project has a probability of a negative NPV of 20 per cent when
=+8 If one project has a higher standard deviation and a higher expected return than another, can we use the mean-variance rule?
=+7 'The flatter the line on the sensitivity graph, the less attention we have to pay to that variable.' Is the executive who made this statement correct in all cases?
=+6 Suggest reasons why probability analysis is used so infrequently by major international corporations.
=+5 Why has the development of powerful computers helped the more widespread adop-tion of scenario analysis?
=+4 Explain the attraction of using more than one method to examine risk in project appraisal.
=+3 Discuss the consequences of the quantification of personal judgements about future eventualities. Are we right to undertake precise analysis on this sort of basis?
=+b Diminishing marginal utility.Standard deviation.
=+2 What do you understand by the following?a Risk-lover,
=+1 Explain, with reference to probability and sensitivity analysis, why the examination of the most likely outcome of an investment in isolation can both be limiting and give a false impression.
=+2 Write a report for a company you know well, describing the extent to which it is exposed to transaction, translation and economic risk. Consider ways of coping with these risks and recommend a
=+1 Examine a recent import or export deal at a company you know well. Write a report detailing the extent of exposure to transaction risk prior to any hedge activity. Describe the risk-reducing
=+Show how the money market can be used to hedge.
=+11 The spot rate of exchange is Won1,507/f between Korea and the UK. The one-month forward rate is Won1,450/f. A UK company has exported goods to Korea invoiced in Won to the value of Won1,507m on

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