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COLLEGE OF HUMANITIES & SOCIAL SCIENCETHE UNIVERSITY OF EDINBURGH BUSINESS SCHOOL
FULL-TIME MBA/MBA IN INTERNATIONAL BUSINESS/DIP BADEGREE EXAMINATION
(EXAMINATION TO BE MARKED ANONYMOUSLY)
FINANCE
(COMPONENT OF MANAGEMENT KNOWLEDGE 1)
Monday 7 December 20092:30pm 4:30pm
Chairman of Board of Examiners: Mr S EarpExternal Examiner: Professor Ian Tonks
Each Question (1 and 2) comprises one half of the exam, counts for 100 marks and shouldtake approximately 60 minutes to answer
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Question 1
Part AGuideline 30 Minutes
EUBS, an educational business, is concerned about the falling rate of growth in its sector. Tohelp you analyse their business prospects, their accountant constructs the followings ratiosfor the years 2000-4:
2000 2001 2002 2003 2004
Profit Margin % 13.68 14.76 16.2 18.6 20.04
Retention Rate % 91.3 91.9 92.8 92.2 86.6
Asset Turnover 73.04 73.52 74.24 73.76 69.28
Assets (end of year) 2436 3118 3681 4923 5483Equity (end of year) 1406 1756 2233 2958 3219
Growth rate in Sales 17.8 16.4 21.4 14 8.5
a) Calculate EUBS sustainable growth rate for each year.Out of 20 Marks
b) Does EUBS have a growth problem? If so, what tools are available to management tomanage the problem?
Out of 10 marks
c) Discuss fully what management should do with the financial and operational tools atits disposal make detailed and specific recommendations.
Out of 20 Marks
(Overall out of 50 Marks)
Part BGuideline 30 Minutes
Interest rates have never been lower so lets borrow everything we can get our hands onproposes Sam the bosss son. He adds Additionally, our debt ratio ( at 70%) is already abovethat of all our competitors (who are at 50%) so by utilising financial leverage we can begin
to use debt to provide really exceptional returns to our equity shareholders.
As a new member of the board you are required to clearly (and respectfully) sketch atheoretical framework to help your fellow board members understand what happens to thecost of capital (debt and equity) when increasing amounts of debt is raised, and in particularwhat happens when your company moves above the gearing for your peer group.
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Question 2
Part AGuideline 20 Minutes
A company wishes to raise $800 million in a new share issue.
Your investment banking advisor suggests that the sale to the market will require a little bit ofunder pricing, say 8 percent with a 7 percent spread. (He mutters that the under pricing is 8percent of the current stock price and the spread is 7 percent of the issue price).
a) Assuming that the companys share price is expected to increase prior to issue dateby 20 percent from its current $75 per share, how many shares must the company
sell and at what price to the company?
b) How much money will the investment banking advisor earn on the sale?Discuss with reference to the pricing of the issue whether management should usedebt markets or equity markets to raise capital?
c) Is the 8 percent under pricing a cashflow? Is it a cost? If so, to whom?
Out of 34 Marks
Part BGuideline 20 Minutes
The return an investor earns on a bond over a period of time is known as the holding periodreturn (HPR), defined as interest income, plus or minus the change in the bond price (dividedof course by the beginning bond price)
a) Based on the logic above what is the HPR on a bond with a par value of $1,000, acoupon rate of 7 percent if its price at the beginning of the year was $1,060 and itsprice at the end was $920. Assume interest paid annually. Discuss fully what featuresthe bond could have added to it to make it more attractive to investors.
b) Explain fully two possible reasons why the bond value may have fallen during theyear?
Out of 33 Marks
Part CGuideline 20 Minutes
A developer of the infamous Halfamiledevelopment in Edinburgh has been trying to shiftpenthouse flats by offering these flats for sale at 120,000 - on the basis of 20,000 downand then 20,000 at the end of the next five years with no interest to be charged.
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FINANCIAL ARITHMETIC
FVt = future value at timeintdex T
PV = present value r= interest rate CF = cash flow
Future value of interest factor(FVIF) at r% and to time t
( )ttr rFVIF += 1,
Present value ofinterest factor (PVIF) atr% from time t
( )ttr
rPVIF
+=
1
1,
Present value interest factorof an annuity (PVIFA) at r%and n periods
( )
+=
nnrrrr
PVIFA1
11,
Future value at time t andinterest rate, given presentvalue
( ) tt
FVrPV =+ 1
Present value givenfuture value at time tand interest rate
( )tt
r
FVPV
+=
1
Present value of an annuity ofperiodic payment amount CFat r% and n periods
( )
+=
nrrr
CFPV1
11
Alternative way of derive the present value of periodic paymentamount PMT at r% and n periods:
niPVIFArPMTPV ,=
Present value of a perpetuity with periodicpayment CF1 at interest rate r%
r
CFPV 1=
Present value of a growth perpetuity with firstpayment CF1 and growth rate g at interest rate r%
gr
CFPV
= 1
CAPITALBUDGETING
k =required rate of return or opportunity cost of capital
Net present value calculation
( )= +
+=n
tt
t
k
CFINPV
10
1
Benefit-Cost NPV
( ) ( )CostPVvenuePVNPV = Re
Profitability index or benefit-cost ratio
( )0I
PVratioCBindexPI =
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BOND VALUATION
Cpn = coupon Prin = principal y= yield on bond
Value of a bond
( ) ( )mmBond
y
in
yyyCpnV
++
+=
1
Pr
1
11
Value of a bond
( )= +
=m
tt
tBond
y
CFV
1 1
EQUITY VALUATION
Dividend growth model Required return on share
gk
DP
= 10 g
P
Dk +=
0
1
Capital gains yield on a share (common stock) Dividend yield on a share (common stock)
( )
1
1
= t
tt
P
PP
yieldgainsCapital 1= t
t
P
D
yieldDividend
WEIGHTED-AVERAGE COST OFCAPITAL
(WACC)
Weighted average cost of capital (WACC) calculation
EquityDebt kED
EkED
DWACC+
++
= E = market value of equityD = market value of debtK equity = required return on equityK debt = required return on debt
After tax WACC TC = corporate tax rate
( ) EquityCDebt kED
ETk
ED
DWACC
++
+= 1
CAPITAL STRUCTURE AND RISK AND RETURN SHARING
Effect of financial leverage on risk of the firm (asset)
ED
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RATIOS
equityrsShareholde
incomeNetequityonturn
'Re =
Assets
incomeNetassetsonturn =Re
equityrsShareholde
Assets
Assets
Sales
Sales
incomeNetequityonturn
'Re =
Assets
Sales
Sales
incomeNetassetsonturn =Re
SalesprofitGrossinmGross =arg
SalesincomeNetinmprofitNet =arg
inventoryEnding
soldgoodsofCostturnoverInventory =
daypersalesCredit
receivableAccountsperiodCollection =
dayperSales
uritiesandCashcashinsalesDays
sec=
dayperSales
uritiesandCashcashinsalesDays
sec=
dayperpurchasesCredit
payableAccountsperiodPayables = equipmentandplantpropertyNet
SalesturnoverassetFixed
,,=
equityrsStockholde
AssetsratioleverageFinancial
'=
incomeNet
DividendsincomeNetratiotention
=Re
assetsTotal
sliabilitieTotalratioassetstoDebt =
( )EquitydebtbearingInterest
rateTaxEBITcapitalinvestedonturn
+
=1
Re
+=
=
rateTax
repaymentincipalInterest
EBITeredburdenTimes
enseInterest
EBITearnederestTimes
1
Prcov
expint
assetsCurrentratioCurrent =
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( )
PRAT
EquityEarningsRR
Equity
equityinChangeggrowtheSustainabl
bop
bop
=
=
=*
( )E
DiROICROICROE '+=
outflowcashTotal
lowcashaverageAnnualreturnofrateAccounting
inf=
( )investment
capitalWorking
enditures
CapitalonDepreciatiTEBIT
flowcash
Free+=
exp1
W
T
K
FCF
firmgrowthnoof
valuealTer1
min += gK
FCF
firmgrowingyperpetuall
ofvaluealTer
W
T
= +1
min
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