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BMAN23000A Two Hours Answer Sheet to be provided Formula Sheet provided Normal Distribution Table provided THE UNIVERSITY OF MANCHESTER FOUNDATIONS OF FINANCE 18 MAY 2016 09:45 - 11:45 Answer ALL questions from SECTION A on the answer sheet provided and Answer ONE question from SECTION B and Answer ONE question from SECTION C Answer Section B and Section C in separate answer booklet(s). (i.e. do not put answers to sections B and C in the same booklet) THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION ROOM Electronic calculators may be used, provided that they cannot store text. PTO Page 1 of 5 BMAN23000A SECTION B (35 marks) Answer ONE question Question 11 (answer all parts) Sports plc expects this year earnings of 6 per share and plans to pay a 2.5 dividend per share, retaining the rest to reinvest in new projects with an expected return of 10% per year. Assuming that Sports plc will maintain the same dividend payout rate and return on new investments in the future and will not change the number of outstanding shares: a) What is the earnings growth rate according to the plans of Sports plc? (5 marks) b) If the equity cost of capital for Sports plc is 8% per year, what is your estimate of its share price? (5 marks) c) Suppose now that Sports plc examines an alternative plan according to which it would instead pay a 1.5 dividend per share and it would retain the remaining earnings for new investment projects that would yield an expected return of 12% per year. However, this alternative payout and investment policy would increase its riskiness, and hence its cost of equity capital would increase to 10% per year. If Sports plc maintains this lower payout rate in the future, what is your estimate of its share price according to this alternative plan? Would you advise the board of directors to adopt this alternative plan? Explain your answer. (15 marks) d) Discuss the limitations of the dividend discount model. (10 marks) (TOTAL 35 marks) PTO Page 2 of 5 BMAN23000A Question 12 (answer all parts) You are asked to compare the following securities: a treasury bill, FTSEALL Index (market portfolio), HighSpeed PLC (a telecommunication company stock), WaterField PLC (a utility company stock) and Metal-Gold PLC (a counter-cyclical company stock). You have collected annual stock prices of each of them and calculated the realized returns for 6 years. You report all realized returns in Table 1 below. year 2009 2010 2011 2012 2013 2014 Treasury bill 3% 2% 1% 1% 1% 1% FTSEALL -4% -2% 3% 7% 11% 12% HighSpeed PLC -3% 2% 7% 12% 12% 14% WaterField PLC 5% 6% 4% 5% 6% 7% Metal-Gold PLC 14% 6% 3% -5% -7% -11% a) Calculate the excess return of each realized return for each security in Table 1. (3 marks) b) Use the excess returns in part a) to calculate the historical average excess returns and volatilities of each security. Show your calculations through the exercise and briefly comment on the results. (You make the assumption that each historical average excess return is a good proxy of the expected return of each security) (6 marks) c) Now using the information in part b), calculate the beta of each security. Briefly interpret the results. (6 marks) d) Once you have calculated the required rate of return of each security using the CAPM formula, indicate whether each security is undervalued or overvalued and explain why. (6 marks) e) Briefly discuss the ways you know to diversify a portfolio. (6 marks) f) Describe what each of the following pairs of asset pricing models has in common, and how they differ: i. APT and CAPM ii. CAPM and F-F-C (Fama-French-Carhart) model iii. F-F-C model and APT (8 marks) (TOTAL 35 marks) PTO Page 3 of 5 BMAN23000A SECTION C (35 marks) Answer ONE question Question 13 (answer all parts) Fan Plc is a publicly traded firm. The market value of its equity is 70,000,000 and its debt 30,000,000. The yield to maturity of the debt is 5%, the shareholders require a 20% return, and the company pays 30% corporate tax. They have recently decided to repurchase 10,000,000 worth of equity, and finance the repurchase through the issuance of new debt. a) Will this change in capital structure affect the market value of the firm? Discuss. (10 marks) b) How will the return on equity be affected by this change? What is the new return on equity of the company? (15 marks) c) A close competitor of Fan Plc has a stock beta of 1.54 when the risk-free rate of return is 4% and the market portfolio offers an expected return of 13%. In addition to equity, the firm finances 40% of its assets with debt that has a yield to maturity of 8%. The firm is in the 30% marginal tax bracket. What is this firm's weightedaverage cost of capital? (10 marks) (TOTAL 35 marks) PTO Page 4 of 5 BMAN23000A Question 14 (answer all parts) a) Describe the market reactions that are typically generated by cash dividend and stock repurchase announcements. Why do these reactions exist? Also, what is dividend smoothing? (10 marks) b) Explain the differences between the following IPO mechanisms: best effort, firm commitment and auction IPO. (5 marks) c) Explain the difference between a secured and an unsecured corporate bond. (5 marks) d) Company ABC is considering opening a hotel. The initial outlay of this investment is 15 million. The present value of the expected cash flows from the hotel is 10 million. Company ABC is convinced that the project could be abandoned in 5 years by selling the hotel for 8 million. The variance in the present value of the cash flows is 0.1. While the opportunity cost of the project is 7%, the (continuously compounded) risk-free rate is 2%. Should the company go ahead with the project? Clearly show your workings and explain each step in your calculations. (15 marks) (TOTAL 35 marks) END OF EXAMINATION PAPER Page 5 of 5