Questions and Answers of Corporate Financial Management

=+2 Explain the meaning of beta.
=+1 Outline the difference between systematic and unsystematic risk.
=+Visit www.pearsoned.co.uk/arnold for further questions, weblinks and an online glossary,
=+2 If you have access to the estimated probability distribution of returns for some projects within the firm, consider the impact of accepting these projects on the overall risk-return profile of
=+1 If you have access to information on financial security return probability profiles then draw up a report showing the efficient frontier for a two-asset portfolio. Draw indiffer-ence curves based
=+e Define the Market Portfolio in Modern Portfolio Theory.
=+d Use indifference curves to select the optimal portfolio to give the highest utility assuming that you are highly risk averse.
=+Describe the efficient and inefficient region.
=+b Display the results on graph paper and draw an estimated portfolio risk-return line based on the plot points for the two-share portfolio. {There is no requirement to calculate the minimum risk
=+To assist your final decision the broker provides you with forecasts by expert City analysts for shares in A and B given various states of the economy - see Table 1.Table 1 State of Probability of
=+b Invest the entire sum in a broad range of investments to reduce risk. This port-folio is expected to produce a return of 23 per cent per year with a standard deviation of 6 per cent.
=+Invest some of the money in A and some in B to give you at least a small degree of diversification. The proportions suggested are given in Table 2 below.
=+When you told your stock broker about this plan he suggested two alternative investment approaches.
=+15(Examination level) You have been bequeathed a legacy of £100,000 and you are considering placing the entire funds either in shares of company A or in shares in company B.
=+You are young and not as risk averse as most people, because you feel you will be able to bounce back from a financial disaster should one occur. Draw indifference curves on the diagram for a
=+State which of the four options are efficient portfolios and which are inefficient given your risk-return line.
=+b Draw a risk and return diagram on graph paper displaying the four options and then add a reasonable risk-return line for all possible allocations between Acchar and Ecaroh. (This is hypothetical
=+Acchar, a consumer electronics firm, is a much more exciting and dynamic but risky firm. Profits vary in dramatic ways with the general level of activity in the economy. If growth is strong then
=+14" (Examination level) Horace Investments Your Uncle Horace is a wealthy man with investments in a variety of businesses. He is also a generous person, especially to his nieces and nephews. He has
=+c Explain the relationship between risk reduction and the correlation between indi-vidual financial security returns.
=+b Calculate the expected return, variance and standard deviation for the following diversifying allocations of Mrs Qureshi's savings:(i) 50% in Ihser, 50% in Resque;(ii) 10% in Ihser, 90% in Resque.
=+13 Suppose that Mrs Qureshi can invest all her savings in shares of Ihser ple, or all her savings in Resque plc. Alternatively she could diversify her investment between these two. There are three
=+b How would you allocate the fund to achieve a zero standard deviation?
=+Calculate the expected return and standard deviation from a portfolio consisting of 50 per cent of F and 50 per cent of G.
=+d Suggest an approach for choosing the optimal allocation of funds assuming a highly risk-averse management.12 Shares in F and G are perfectly negatively correlated.F 17 6G 24 10
=+c Calculate the expected return and standard deviation for a series of four other possible allocations of the funds and construct a risk-return line.
=+b An alternative to selecting one project or the other is to split the available invest-ment funds between the two projects, Now calculate the expected return and standard deviation if half of the
=+11 Big Trucks ple is considering two major projects. The first is to expand production at the Midlands factory. The second is to start production in the Far East. The returns in terms of internal
=+d Select an optimal portfolio for a slightly risk-averse investor using indifference curves.
=+c Create a diagram showing the feasible set and the efficient frontier.
=+b Calculate the minimum standard deviation available by varying the proportion of Trent and Severn shares in the portfolio.
=+9 Using the results generated in Question 8 and three or four additional calculations, display the efficient frontier for a two-asset portfolio consisting of S and T.Show a set of indifference
=+Determine a portfolio expected return and standard deviation if two-thirds of a fund are devoted to S and one-third devoted to T.
=+What are the covariance and the correlation coefficient between returns on S and returns on T?
=+b Calculate the expected return and standard deviation for share T.
=+8 The returns on shares S and T vary depending on the state of economic growth.State of economy Probability of Returns on S if Returns on T if economic state economic state economic state occurring
=+b What is the expected return and standard deviation for a portfolio composed of 30 per cent of X and 70 per cent of Y, assuming X and Y have a correlation coef-ficient of +0.5?
=+7 Given the following expected returns and standard deviations for shares X and Y, Rx = 25%, Ry 35%, x = 15%, y = 20%
=+b Calculate the correct allocation of resources between ICMC and Splash which will give the minimum standard deviation. Draw a risk-return line on graph paper using the data you have generated from
=+6" a Given the data on the Ice Cream Manufacturing Company (ICMC) in Question 4 and Splash plc in Question 5, now calculate the expected returns and standard deviation of the following
=+b The standard deviation of a share in Splash plc.
=+when a particular weather 'event' may occur.Event Probability Returns on shares in Splash ple (%)Hot weather 5Modestly warm 0.6 15 Cold weather 0.2 20 1.0 Calculate aThe expected return for a share
=+5" Splash ple owns a swimming pool near to a major seaside resort town.Holidaymakers boost the turnover of this firm when they are unable to use the beach on cold and wet days. Thus Splash's
=+b What is the standard deviation of that return?
=+What is the expected return?
=+4º (Examination level if combined with Questions 5 and 6) The probability of a hot summer is 0.2. The probability of a moderately warm summer is 0.6, whereas the probability of a wet and cold
=+3 Shares in Whitchat plc can be purchased today for £1.20. The expected dividend in one year is 5p. This is expected to be followed by annual dividends of 6p and 7p respectively in the following
=+months and sold for £5. The purchase price was £4.80 and no dividend is payable.
=+2 Calculate the percentage holding-period return for a share which is held for three
=+12 How are the gains from diversification linked to correlation coefficients?
=+11 Describe why investors do not routinely calculate portfolio standard deviations and indifference curves.
=+10 Why is the standard deviation on a portfolio not a weighted average of the standard deviations of the constituent securities?
=+9 'The objective of portfolio investment is to minimise risk.' Do you agree?
=+8 A risk-averse investor currently holds low-risk shares in one company only. In what circumstances would it be wise to split the fund by purchasing shares in a high-risk and high-return share?
=+7 Illustrate the efficient frontier and explain why all portfolios on the frontier are not necessarily optimal.
=+6 Explain the necessary conditions for the standard deviation on a portfolio to be zero.
=+5 Show how the covariance and correlation coefficient are related.
=+4 How are holding-period returns calculated?
=+3 What are indifference curves and why can they never intersect?
=+2 What is a dominant portfolio?
=+1 How do you calculate the risk on a two-asset portfolio?
=+For a project of this risk class a minimum return of 14 per cent is considered acceptable.Assume no inflation.Required
=+4* (Examination level) Wishbone ple is considering two mutually exclusive projects.Project X requires an immediate cash outflow of £2.5m and Project Y requires £2m. If there was no inflation then
=+Calculate the net present value of this investment.
=+The cash flows are confined to within the lifetime of each project.The cost of capital is 10 per cent.No inflation.No tax.
=+8" (Examination level) Clipper ple is considering five project proposals. They are sum-marised below:Project Initial Annual Annual fixed Life of project mvestment revenue
=+7" Bedford Onions ple is examining the possibility of purchasing a machine for a new venture. The machine will cost £50,000, have a four-year life and a scrap value of€10,000. An additional
=+The required rate of return is 10 per cent.
=+If the machine has a scrap value of £1,000 after five years, what will be the fifth year's adjustment to the WDA?
=+6 A machine costs £10,000 and has a five-year life. By how much can taxable profit be reduced through the writing-down allowance (WDA) in the third year, if the annual WDA is 25 per cent on a
=+b Now assume that the general inflation rate is anticipated to be 8 per cent per annum. Calculate the real cash flows and the real cost of capital and use these to calculate the NPVs.
=+a Use the money cash flows and money cost of capital to calculate the NPV of the two projects and recommend the most appropriate course of action.
=+These cash flows can be assumed to arise at the year ends of each of the three years.Specific annual inflation rates have been estimated for each of the cash flow elements.Sales 5%Materials
=+Annual cash flows Project X Project Y Inflow from sales Cash outflows: Materials 2,100,000 1,900,000 800,000 200,000 Labour 300,000 700,000 Overheads 100,000 50,000 (1,200,000) (950,000) Net cash
=+All cash flows occur on anniversary dates.
=+If the firm has a limit of £40,000 for investment in projects at Time 0, what is the opti-mal allocation of this sum among these projects, and what is the maximum net present value obtainable?
=+9 (Examination level)Oppton ple's managers are ambitious and wish to expand their range of activities.
=+None of the projects lasts more than four years and cash flows are confined to within the four-year horizon.Assume-
=+2 Write a report on how inflation and tax are allowed for in project appraisal within a firm you know well. To what extent are the rules advocated in this chapter obeyed?
=+v1 Investigate the capital rationing constraints placed on a firm you are familiar with. Are these primarily soft or hard forms of rationing? Are they justified? What are the eco-nomic costs of
=+Now calculate profitability indices (or benefit-cost ratios) for each project and cal-culate the maximum potential NPV if the £38m limit is adhered to.
=+What is the maximum NPV available if projects are selected on the basis of NPV alone?
=+- All projects are divisible (a fraction of the project can be undertaken), and none can be undertaken more than once.
=+The rate of return required on projects of this risk class is 10 per cent.All project cash flows are confined within the five-year period.
=+The strategic planning group are keen on getting approval for the release of 42m to invest in all these projects. However, Cartma is a subsidiary of PQT and the holding company board have placed
=+10 Cartma ple's superb strategic planning group have identified five projects they judge to be shareholder wealth enhancing, and therefore feel that the firm should make these investment
=+b Distinguish between "soft' and 'hard' capital rationing and explain why these forms of rationing occur.
=+What is the optimal allocation of the £110,000 and the resulting net present value?
=+The cost of capital is 10 per cent.No inflation.-No tax.All cash flows occur on anniversary dates.
=+limit on the amount spent in any one period. In the case of Oppton this limit is to be £110,000 at Time 0 for these projects, which if accepted will commence imme-diately. The five projects are
=+a They have produced a report for the parent company's board of directors detailing five projects requiring large initial investments. After reading the report the main board directors said that
=+The management judge that the cash inflows shown above are also an accurate esti-mation of the profit before depreciation for each of the years. They also believe that the appropriate discount rate
=+Allocated overhead consists of central administrative costs which are incurred with or without this project. The machine will be eligible for a 25 per cent writing-down allowance (on a declining
=+1 Payback is dismissed as unsound. Discuss.
=+The initial £900,000 investment in plant and machinery is to be depreciated over the five-year life of the project using the straight-line method. These assets will have no value after Year 5.
=+(1) a Calculate the payback period.b Calculate the discounted payback period.
=+c Calculate an accounting rate of return.d Calculate the internal rate of return.
=+e Calculate the net present value.
=+(2) Compare the relative theoretical and practical merits and demerits of each of the methods used.Assume: No tax or inflation.4 A firm is considering investing in a project with the following cash
=+The initial investment is £6,250. The firm has a required rate of return of 10 per cent.Calculate:a the payback period;

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