Foundations of Finance Handbook TD

School of Economics, Finance and Business

MODULE CODE: ECOS 1011 MODULE NAME: FOUNDATIONS OF FINANCE October 2011

PLEASE RETAIN THIS HANDBOOK FOR FUTURE REFERENCE. IT MAY BE REQUIRED FOR SUBMISSION TO PROFESSIONAL BODIES WHEN APPLYING FOR EXEMPTION FROM EXAMINATIONS.

1. Contents 1. Contents .......................................................................................................... 2 2. Teaching Staff .................................................................................................. 3 3. Module Information ........................................................................................ 3 4. Delivery Mechanisms ...................................................................................... 4 5. Summative Assessment ................................................................................... 4 6. Formative Assessment .................................................................................... 4 7. Classes ............................................................................................................ 5 8. Assessment Criteria ......................................................................................... 5 9. Seeking Help ................................................................................................... 6 10. DUO .............................................................................................................. 6 11. Textbooks ...................................................................................................... 7 12. Module Syllabus ............................................................................................ 8 13. Class Sheets ................................................................................................. 12 Sheet One ................................................................................................................................ 12 Sheet Two ............................................................................................................................... 13 Sheet Three ............................................................................................................................. 15 Sheet Four ............................................................................................................................... 17 Sheet Five ............................................................................................................................................................. 19 Sheet Six ............................................................................................................................................................... 22 Sheet Seven ......................................................................................................................................................... 24 Sheet Eight .......................................................................................................................................................... 26 Formative Seminar .......................................................................................................................................... 27 N.B. This handbook is intended for the guidance of students taking this module in 2011/2012. Whilst the details contained in this handbook represent teaching staff intentions at the time of writing, it is in the nature of higher education that some module information, such as syllabus, reading lists and assignments, may be subject to modifications during the teaching of a module. Teaching staff reserve the right to make such minor changes in the matters covered by this publication and will endeavour to publicise any such changes as widely and timely as possible.

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2. Teaching Staff Lectures Mr Daniel (Jun) Hua 0191 33 45201 Class Tutors Mrs Sunitha Vijayakumaran [email protected] Office hours will be posted on DUO. [email protected] Dr Toby Watson (Module Leader) 0191 33 46338/40146 [email protected]

3. Module Information The following information is included in the Module Outline, which is available at http://www.dur.ac.uk/faculty.handbook/module_description/?year=2011&mod ule_code=ECOS1011 : Prerequisites and corequisites (where appropriate) Module Aims Learning Outcomes, including subject-specific knowledge, subject-specific skills and key skills.

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4. Delivery Mechanisms Lectures Revision Lectures Classes* Classes, of which there are nine throughout the year, provide a structured programme of work designed to reinforce knowledge and encourage independent study. Eight of the classes are tutorials and the questions for these are shown later in the handbook. The remaining class is a seminar and will be used for the formative group presentations. All students are expected to have read about the subject of the presentations and to be prepared to enter into discussion of the issues. * Students will be provided with details of the precise split of the classes over the terms. Number 38 4 9 Frequency 2 per week (double lecture) In the Easter term Across the three terms 1 hour Duration

5. Summative Assessment This module is summatively assessed by means of an examination in May/June. You should refer to the Programme Handbook (see the section "Assessment of Performance") for information on how we mark. Past exam papers are available for your consultation on duo via the Library tab, but solutions/model answers will not be provided.

6. Formative Assessment The main aim of the formative assessment is to help you, in a structured way, to understand the material and its applications, consolidate your knowledge and further develop relevant skills. Students will undertake two formative assessments during the year. The first will be a group presentation near the beginning of the Epiphany term, the second a multiple choice test delivered via duo near to the end of the Epiphany term. An outline of the requirements for the group presentation are given on page 27. More details of the group presentation, as well as the seminar class in which it is to take place, will be provided nearer the time. The formative test will be administered via duo and students will receive full details in the Epiphany term.

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7. Classes Non-lecture classes, of which there are nine throughout the year, are designed to give students the opportunity to explore issues in depth and to enter into discussion and debate on issues in finance. Questions for the classes are shown later in this handbook. All students are expected to prepare answers to all questions for each class and to be prepared to enter into discussion of the issues. In each class a random sample of work from a number of students will be collected; this will be marked and returned in the next class. The tutor in charge of the class will take a lead, but students are expected to make major contributions. Attendance at all classes is compulsory. You must attend the group which you have been allocated to, unless there are circumstances beyond your control that prevent this such as illness. In which case, check with the seminar tutor to ensure there is space in an alternate group. You must also notify the programme office.

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8. Assessment Criteria Performance in the formative and summative assessments for the module is judged against the following criteria:

Relevance to question(s) Organisation, structure and presentation Depth of understanding Analysis and discussion Use of sources and referencing Overall conclusions

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9. Seeking Help All members of the teaching team will have consultation hours where they will be pleased to talk to students. The days/times of consultation hours will be posted on duo. If you wish to ask questions about the material you should first talk to your seminar tutor in their consultation hour and, where appropriate, the consultation hour of the lecturer delivering that part of the module. Normally, your tutors will expect you to have devoted some study time to addressing problems yourself first and they will want to ascertain your understanding (e.g. rather than simply providing answers to numerical problems). Seminars also provide a good opportunity to discuss any questions you might have with your peers and the seminar leader. Overall problems, general enquiries or concerns relating to the module should be brought to the attention of the Module Leader as soon as possible. If you have serious problems that relate more generally to your studies across this and other modules please see the Programme Handbook for guidance. In such cases, you should normally see your Course Leader or, for issues relating to assessment, the Chair/Deputy Chair of the Board of Examiners. However, full details of the support mechanisms that are in place are detailed in the Programme Handbook.

10.

DUO

Teaching staff will place information on DUO as appropriate. All students are expected to consult the modules DUO site regularly. Whilst some lecture notes and other useful/supporting information may be placed on DUO, students should note that this material is intended as a useful complement to, and not a substitute for, attendance at lectures. In particular, not everything covered in lectures will be available on DUO. The teaching team may also choose to use the whiteboard and/or visualiser to present elements of topics, for example building up diagrams whilst discussing the meaning, so as to aid student understanding. Other examples might include working through numerical examples step-by-step. Naturally, students are expected to take notes as such material will not normally be replicated on duo.

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11.

Textbooks

There are many excellent introductory textbooks, all of which cover much the same material. It is expected that students will purchase one of these books, since by purchasing one text easy access to at least one essential source of material is guaranteed. It is also vital, and cannot be overstressed, that lecture material is supplemented through consulting a variety of different sources. Essential reading is identified below, with the module being most closely based on the text by Keown, Martin and Petty. Boakes provides a good linkage to the real world there are many articles in the text that you can relate to the theoretical concepts covered in lectures. Many seminars have one or more questions derived from articles presented in Boakes. You should also undertake your own search for additional relevant literature and follow up relevant references contained in the literature identified below. It is also highly recommended that you read the financial press on a regular and frequent basis to gain an understanding of how theory relates to practice. Core Texts Keown, A.J., Martin, J.D. and Petty, J.W. (2010) Foundations of Finance. 7th international edn. Pearson Prentice Hall. Boakes, K. (2010) Reading and Understanding the Financial Times. 2nd edn. Financial Times Prentice Hall. NOTE: Boakes is also available as an online e-book via the Library catalogue at http://library.dur.ac.uk/record=b2616122~S1 accordingly, you may decide you wish to read this electronically rather than purchasing a copy. Other Excellent Texts Brealey, R.A., Myers, S.C. and Marcus, A.J. (2008) Fundamentals of Corporate Finance. 6th edn. McGraw-Hill. McLaney, E. J. (2011) Business Finance: Theory and Practice. 9th edn. Financial Times Prentice Hall Pike, R. and Neale, B. (2006) Corporate Finance and Investment. 6th edn. Financial Times Prentice Hall. Ross, S.A., Westerfield, R.W. and Jordan, R.D. (2010) Fundamentals of Corporate Finance. 9th edn. McGraw-Hill. Van Horne, J.C., and Wachowicz, J.R. (2008) Fundamentals of Financial Management. 13th edn. Pearson Prentice Hall.

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12.

Module Syllabus

Essential reading is identified below. Additional references will be provided during the year. 1. An Introduction to Finance What is finance about? The importance of financial decisions. An introduction to sources of long-term funds. Forms of business organisation. The financial objectives of the corporation. Keown, Martin and Petty, Chapter 1. Brealey, Myers and Marcus, Chapter 1. Ross, Westerfield and Jordan, Chapter 1. Van Horne and Wachowicz, Chapter 1. 2. Basic Mathematics of Finance An introduction to the mathematics of finance. The time value of money. Future and present values of cash flows. Compounding and discounting. Keown, Martin and Petty, Chapters 2 (pages 35-39) and 5. Brealey, Myers and Marcus, Chapter 4. Ross, Westerfield and Jordan, Chapters 5 & 6. Van Horne and Wachowicz, Chapter 2. 3. Sources and Valuation of Long-term Funds The role of capital markets. The characteristics of loan capital. The advantages and disadvantages of long-term debt financing. The characteristics of equity capital. The advantages and disadvantages of equity financing. Valuing shares: the basic share valuation model; discounting dividends; the constant dividend formula; the dividend growth model. Valuing debenture stock: nominal yield; current yield; the yield to maturity. Keown, Martin and Petty, Chapters 7 and 8. Brealey, Myers and Marcus, Chapters 5 and 6. Ross, Westerfield and Jordan, Chapter 7 and 8. Van Horne and Wachowicz, Chapter 4. Boakes article 21.

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4. Investment Appraisal under Certainty The importance of the investment decision. The role of investment appraisal techniques. The payback method. The accounting rate of return method. The net present value (NPV) approach. The internal rate of return (IRR) method. NPV and IRR compared. Keown, Martin and Petty, Chapter 10. McLaney, Chapter 5 Brealey, Myers and Marcus, Chapters 7 and 8. Ross, Westerfield and Jordan, Chapters 9, 10 and 11. Van Horne and Wachowicz, Chapters 12 and 13. Boakes article 24. 5. Investment Appraisal in Practice Relaxing the assumption of full knowledge. Data requirements. Inflation and investment appraisal. Risk and uncertainty: the risk-adjusted discount rate; the expected net present value method; sensitivity analysis; game theoretic approaches. Controlling the investment process. The use of investment appraisal techniques. Keown, Martin and Petty, Chapter 11. McLaney, Chapter 6 Ross, Westerfield and Jordan, Chapter 11. A. Sangster, (1993) 'Capital Investment Appraisal Techniques: A Survey of Current Usage', Journal of Business, Finance and Accounting, pp. 307-332. Van Horne and Wachowicz, Chapter 13. R. Pike (1996) 'A Longitudinal Survey on Capital Budgeting Practices', Journal of Business Finance and Accounting, pp. 79-92. G.C. Arnold and P. D. Hatzopoulos, (2000) The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business, Finance and Accounting, pp.603-626. 6. Risk Using basic quantitative methods to measure risk and expected return. Explaining the concept of investment diversification. Distinguishing between systematic and unsystematic risk and explaining how systematic risk is measured. Keown, Martin and Petty, Chapter 6. McLaney, Chapter 7. Bodie, Z., Kane, A. and Marcus, A. (2008) Essentials of Investments. 7th internation edn. McGraw-Hill, Chapters 5 & 6 Brealey, Myers and Marcus, Chapters 10 & 11. Ross, Westerfield and Jordan, Chapters 12 & 13. Van Horne and Wachowicz, Chapter 5.

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7. The Cost of Capital This component of the course will seek to investigate the cost to firms of raising the necessary capital to fund investments. This includes explaining and calculating the cost of equity and debt capital and the weighted average cost of capital. Keown, Martin and Petty, Chapter 9. McLaney, Chapters 10 & 11. Brealey, Myers & Marcus, Chapter 12. Ross, Westerfield & Jordan, Chapter 14. Van Horne and Wachowicz, Chapter 15. Boakes article 18. 8. Financing Decisions This topic is focused on the practicalities of raising capital. Initial public and seasoned offerings of equity, rights issue and debt issues. There will also be a basic introduction to capital market efficiency. Keown, Martin and Petty, Chapter 2. McLaney, Chapters 8 & 9. Brealey, Myers & Marcus, Chapters 13 & 14. Bodie, Z., Kane, A. and Marcus, A. (2008) Essentials of Investments. 7th internation edn. McGraw-Hill, Chapters 3 and 8 Ross, Westerfield & Jordan, Chapter 15. Van Horne and Wachowicz, Chapter 19. E. Fama, (1970), Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25, pp. 383-417. Boakes articles 19 & 20.. 9. An Introduction to Capital Structure The debt-equity ratio. Leverage effects, financial distress and the cost of capital. Keown, Martin and Petty, Chapter 12. Brealey, Myers and Marcus, Chapter 15. Ross, Westerfield and Jordan, Chapter 16. Van Horne and Wachowicz, Chapter 17. Boakes article 16 and those in Topic 5. 10. Dividends and Dividend Policy What are dividends? The mechanics of paying dividends. Does dividend policy matter? Stock repurchases, stock dividends and stock splits. Keown, Martin and Petty, Chapter 13. McLaney, Chapter 12. Brealey, Myers and Marcus, Chapter 16. Ross, Westerfield and Jordan, Chapter 17. Van Horne and Wachowicz, Chapter 18. Boakes article 16 and those in Topic 9. Page 10 of 27

11. Financial Planning How the firm can make use of the information from both financial statements and market prices to inform the financial decision making process? Keown, Martin and Petty, Chapters 4 and 14. Brealey, Myers and Marcus, Chapters 17 and 18. Ross, Westerfield and Jordan, Chapters 3 and 4. Van Horne and Wachowicz, Chapters 6 and 7. E.I. Altman, (1968) Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance, 23, pp. 598-609. 12. Working Capital Management How the firm performs the daily management of its inventory, cash and credit. Models for determining optimal cash and inventory holdings. Keown, Martin and Petty, Chapter 15 and 16. McLaney, Chapter 13. Brealey, Myers and Marcus, Chapters 19, 20 and 21. Ross, Westerfield and Jordan, Chapters 19 and 20. Van Horne & Wachowicz, Chapters 8, 9 and 10. 13. International Financial Management An introduction to the problems faced by financial managers when dealing with foreign exchange. How hedging can be used to reduce risk Keown, Martin and Petty, Chapter 17. Brealey, Myers and Marcus, Chapter 23. Ross, Westerfield and Jordan, Chapter 21. Van Horne and Wachowicz, Chapter 24. Boakes article 31.

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Seminar Class Sheets

13. Sheet One

Class Sheets

Prior to the class all students should prepare answers to the following questions: 1. What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant. 2. What are the major disadvantages of the sole proprietorship and partnership forms of business organisation? What benefits are there to these types of business organisation as opposed to the corporate form? Why are some sole proprietors unwilling to change the form of business organisation to the corporate form? 3. What is the primary disadvantage of the corporate form of organisation? Name at least two of the advantages of corporate organisation. 4. Why do we assume that the goal of a private-sector organisation is to maximise shareholder wealth? 5. Who owns a corporation? Describe the process whereby the owners control the firms management. What is the main reason that an agency relationship exists in the corporate form of organisation? In this context, what kind of problems can arise? Name some other areas of activity in which an agency relationship exists. 6. What is the difference between primary and secondary capital markets? Why is the existence of secondary markets important? 7. Can the goal of maximising the value of shares conflict with other goals, such as avoiding unethical or illegal behaviour? In particular, do you think subjects like customer and employee safety, the environment and the general good of society fit in this framework, or are they essentially ignored? Use some specific scenarios to illustrate your answer. 8. Consider Articles 2 and 3 together with the associated discussion in Boakes (pp.9-13). Come prepared to discuss these in the seminar and the following points in particular: a. Does the stepping down of Logicas chief executive seem consistent with the goal of maximising shareholders wealth and directors running the firm as agents? b. As Boakes asks: In what situations might we expect there to be a significant increase in the number of activist shareholders in a company? c. Discuss how company shareholders can encourage their managers to act in a way which is consistent with the objective of shareholder wealth maximisation. Page 12 of 27

Sheet Two


Prior to the class all students should prepare answers to the following questions: 1. What is meant by the term the time value of money and why is it important? 2. Why is the concept of the present value superior to that of the future value for comparing investment opportunities? 3. As you increase the length of time involved, what happens to future values? What happens to present values? 4. What happens to a future value if you increase the rate r? What happens to a present value? 5. Use discount tables to show the present value of the following sums of money: a. 150 to be received in 12 years when the discount rate is 10% b. 275 to be received in 9 years when the discount rate is 8% c. 5,500 to be received in 6 years when the discount rate is 16% d. 4,250 to be received in 11 years when the discount rate is 14% 6. A company has the opportunity to undertake an investment costing 13,500 which will generate net cash flows in each of the next seven years of 3,000. Use discount tables to calculate the present value of the future cash flows: a. when the discount rate is 7% b. when the discount rate is 10% c. when the discount rate is 18% 7. What is the present value of a perpetuity of 500 per annum when the discount rate is: a. 9% b. 18% c. 24% 8. How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required rate of return on a bond. 9. Is the yield to maturity (YTM) on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 per cent coupon bond sells at par. Two years from now, the required return on the same bond is 8 per cent. What is the coupon rate on the bond at that time? What is the YTM?

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10. Suppose you buy a 7 percent coupon, 20-year bond today when it is first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond (you do not have to provide a numerical value)? Why? 11. Queen's Ltd has 6 percent coupon bonds on the market that have 12 years left to maturity. The bonds have a face value of 100 and make annual payments. If the YTM on these bonds is 9 percent, what is the current bond price? 12. If Treasury bills are currently paying 8 percent and the inflation rate is 6 percent, what is the approximate real rate of interest? What is the exact real rate?

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Sheet Three


Prior to the class all students should prepare answers to the following questions: 1. Why does the value of a share of stock depend on dividends? 2. A substantial percentage of the companies listed on leading stock exchanges dont pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible given your answer to the previous question? 3. Under what two assumptions can we use the dividend growth formula to determine the value of a share? Comment on the reasonableness of these assumptions. 4. Martins plc has just paid a dividend of 0.30 per share on its stock. The dividends are expected to grow at a constant rate of 5 per cent per year indefinitely. If investors require a 12 percent return on Martins plc, what is the current price? What will be the price in 3 years? In 15 years? 5. Consider Article 21 in Boakes (pp.114-116). The article says that Few analysts discounted cash flow valuations are above 400p. How can you reconcile this with the private equity bid of 585p and the stock price of 560p? How does a low terminal growth rate influence the 400p valuation? 6. The next dividend payment by OBA Ltd will be 0.40 per share. The dividends are anticipated to maintain a 6 percent growth rate forever. If OBA Ltd stock currently sells for 4.50 per share, what is the required return? 7. Smashed Pumpkin Farms (SPF) just paid a dividend of 0.45 on its stock. The growth rate in dividends is expected to be a constant 7.5 per cent per year, indefinitely. Investors require an 18 percent return on the stock for the first three years, an 11 percent return for the next three years and then a 12 percent return thereafter. What is the current share price for SPF stock? (Hint: To answer this question you must begin by calculating the price in year 6, then the price in year 3, then the price now). 8. Lost Bearings Ltd. is a young start up company. No dividends will be paid on the stock over the next five years, because the firm needs to plough back its earnings to generate growth. The company will then pay a 0.60 per share dividend and will increase the dividend by 5 percent per year, thereafter. If the required return on this stock is 23 percent, what is the current share price? 9. What are the reasons why debt capital in a firm typically has a lower cost of capital than does equity capital in the same firm? Will debt capital in a firm always have a lower cost of capital than equity capital in a different firm? Why or why not? 10. Why is the investment decision of importance to firms? 11. Which of the following purchases would normally be considered to be worthy of investment appraisal (explain your answer in each case):

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Seminar Class Sheets a. buying a new computer system; b. buying software for a computer; c. purchasing a photocopier; d. purchasing supplies of paper for use in a photocopier; e. building an extension to a factory; f. refitting the company gym and social club; g. undertaking a new advertising campaign?

12. What are the main stages of the investment decision making process?

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Sheet Four


Prior to the class all students should prepare answers to the following questions: 1. Do investment appraisal techniques provide decision makers with decision advice that they definitely should follow? Why or why not? 2. Concerning the payback: a. Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule? b. What are the problems associated with using the payback period as a means of evaluating cash flows? c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? 3. Concerning NPV and IRR: a. Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule? b. Why is NPV considered to be a superior method of evaluating the cash flows from a project? Suppose the NPV for a projects cash flows is computed to be 2,500. What does this number represent with respect to the firms shareholders? c. Describe how IRR is calculated and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule? 4. A project that provides annual cash flows of 400 for eight years costs 1500 today. Use the NPV and IRR methods to determine whether this is a good project if the required return in 6%. What if the required return is 22%? At what discount rate would you be indifferent between accepting the project and rejecting it? 5. What is the IRR of the following set of cash flows? Year 0 1 2 3 Page 17 of 27 Cash flow () -1,300 400 300 1,200


6. For the cash flows in the previous question, what is the NPV at a discount rate of zero percent? What if the discount rate is 10%? If it is 20%? If it is 30%? 7. To what extent should accounting conventions be included in the investment appraisal process? 8. Why should inflation be taken into account when appraising investment opportunities? 9. In the presence of inflation, there are two interest rates: the nominal rate and the real rate. Which should be used in the investment appraisal process? 10. Distinguish between risk and uncertainty. 11. Consider Article 22 and the associated discussion in Boakes (p.118). What is the difference between business risk and financial risk and can you identify the risks that appear to apply to Woolworths as presented in the article? 12. Outline the main problems associated with the use of the ENPV approach. 13. Explain the principle underlying the risk adjusted discount rate approach. Why might the use of a higher discount rate to reflect increased risk be unwise in some circumstances?

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Sheet Five


Prior to the class all students should prepare answers to the following questions: 1. Why is sensitivity analysis of assistance to decision makers appraising investment opportunities? 2. A company is considering launching a new product and believes that the success of the project will depend upon the state of the economy over the next few years. It estimates that there are three likely states of the economy: boom, neutral and recession and that the product will have a life of four years. On this basis, it estimates the net cash flows as shown in the table: Year NCFs - Boom NCFs Neutral NCFs (s) (s) Recession (s) -75,000 35,000 35,000 35,000 35,000 -75,000 27,000 27,000 27,000 27,000 -75,000 18,000 18,000 18,000 18,000 -

0 1 2 3 4

The likelihood of each state of the economy occurring is estimated to be: boom: 0.25 neutral: 0.4 recession: 0.35 a. Calculate the NPV for each state of the economy, assuming a discount rate of 10% b. Calculate the ENPV of the project.

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3. A firm is undertaking an investment appraisal for a new product and estimates the main components of the cash flows over the 8 year life of the project to be as follows: Item Cost of refitting factory Costs of new machinery Labour costs Advertising costs Raw materials costs Energy costs Sales Revenue The discount rate is 24%. a. Calculate the NPV of the project. b. Determine the value of the NPV when each of the estimated figures is varied (one at a time) by +25% and -25%, NB the relevant discount factor using a discount rate of 30% and an annuity for eight years is 2.9247 (this is not given in the textbook). Assume the life of the project is fixed. c. What key information can the decision maker draw from this sensitivity analysis? 4. In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk? 5. You own a portfolio that has 600 invested in stock A and 1200 invested in stock B. If the expected returns on these stocks are 13% and 22% respectively, what is the expected return on the portfolio? 6. Assume the returns on shares of Pear Computers and Banana Information Systems over the next year are contingent on the state of the world given below. Cash flow (000) 1,100 550 60 40 50 80 735 estimate Year(s) of cash flow 0 0 1-8 1-8 1-8 1-8 1-8

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State of World 1 2 3


Probability 0.2 0.3 0.5

Pear 6% 10% 10%

Banana 14% 10% -2%

Calculate the expected return, variance and standard deviation of returns on an equally weighted portfolio of the two shares. 7. A stock has an expected return of 17%, its beta is 0.9, and the risk-free rate is 7.5%. What must the expected return on the market be? 8. Stock Y has a beta of 1.59 and an expected return of 25%. Stock Z has a beta of 0.44 and an expected return of 12%. If the risk-free rate is 6% and the market risk premium is 11.3%, are these stocks correctly priced? 9. Consider the following information on stocks I and II: State of Economy Recession Normal Boom The market risk premium is 8%, and the risk-free rate is 6%. Which stock has the most systematic risk? Which stock has the most unsystematic risk? Which stock is riskier? Explain. Probability of State of Economy 0.2 0.55 0.25 Rate of return if state occurs Stock I 0.06 0.47 0.23 Stock II -0.25 0.11 0.68

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Sheet Six


Prior to the class all students should prepare answers to the following questions: 1. Explain why the cost of capital and required return may be regarded as two sides of the same coin. 2. Cunningham and Reilly Crane Hire plc has common stock with an ex dividend market price of 0.70 per share and a constant expected annual dividend growth rate of 5%. A dividend of 0.10 per share has just been paid. Calculate C & R's cost of equity capital. 3. Steyn & Nel plc has preferred stock trading at 65. The annual dividend on the preferred stock is 2.80 per share. What is the cost of Steyn & Nels preferred stock? 4. Manic Sweet Peaches plc has 500,000 shares of common stock outstanding and 50,000 bonds outstanding. The stock is trading at 7.50 per share and the cost of equity is 12%. The face value of a bond is 100 and the debt is selling at 110% of par with a yield to maturity of 9%. The rate of corporation tax is 31%. Calculate MSPs WACC. 5. Gausden & Bennison Ltd. need to raise 7.5 million to start a new project. The company has a target capital structure of 60 % common stock, 10 % preferred stock, and 30% debt. Flotation costs for issuing new stock are 15%, for new preferred stock, 7%, and for new debt, 4%. What is the true initial cost figure G&B should use when evaluating its project? 6. The Rock Bottom Pub Company Limited are considering opening a new super-pub in Thornaby. The cost of the project will be 700,000 and it is expected to generate net cash flows of 120,000 per year in perpetuity. The company has a target debt/equity ratio of 1, a flotation cost of debt of 6%, a flotation cost of equity of 12%, a yield-to-maturity of 9% and a required return on equity of 15%. The rate of corporate taxation is 30%. Should the firm proceed with the project? 7. Under what circumstances is the WACC an appropriate measure of the discount rate for a project? Are these circumstances likely to hold in practice? 8. Ordinary shares of Jack Rabbit Slim Ltd. are currently quoted at 3 each. JRS announce a rights issue where each existing shareholder is given the right to purchase one share at 1.75 for each five shares held. Mr Wallace currently holds 10,000 shares in JRS. a. How many shares is Mr Wallace entitled to buy at the new price? b. What is the ex rights share price? c. Assuming he exercises his rights, what is the total value of his new shareholding? d. What is one right worth?

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Seminar Class Sheets e. Mr Vega, who holds 1,000 shares, does not exercise his right; what is his holding now worth?

9. Explain how a rights issue differs from a general cash offer. 10. Tony Rocky Horror Meat Pies plc wants to raise 2.35m via a rights offering. The company currently has 250,000 shares of common stock outstanding that sell for 30 per share. Its underwriter has set a subscription price of 25 per share and will charge TRHMP a 6% spread. If you currently own 5,000 shares of stock in the company and decide not to participate in the rights offering, how much money can you get by selling your rights? 11. Honeybunny plc needs to raise 12m to finance an expansion into new markets. A general cash offering of new shares of equity will be undertaken to raise the required funds. If the offer price is 22 per share and the company's underwriters charge an 8% spread, how many shares need to be sold? 12. Pumpkin plc has recently gone public. Under a firm commitment agreement Pumpkin receives 14 for each one of the 1.5 million shares sold. The initial offering price was 15 per share, and the stock price rose to 17 per share in the first few minutes of trading. Pumpkin paid 250,000 in direct legal and other costs, and 100,000 in indirect costs. What was the fDisclotation cost as a percentage of funds raised? 13. Flock of Seagulls Inc. has 100,000 shares of stock outstanding. Each share is worth $75, so the company's market value of equity is $7,500,000. Suppose the firm decides to issue 25,000 new shares and considers the following offering prices: $75, $50, and $25. What will the effect be of each of these alternative offering prices on the existing price per share? 14. Read Articles 19 and 20 and the associated discussion in Boakes (p.109). According to Article 20, Hargreaves Lansdown shares opened at 160p and rose to close at 209p, adding 232.4 m in value Think about the following points and come prepared to discuss them in the seminar: a. Why might the shares have risen in value so much on the first day? b. How does this rise in price reflect on the indicative pricing range of 140-160p? c. What kind of cost does this rise in price represent?

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Sheet Seven


Prior to the class all students should prepare answers to the following questions: 1. A trader at Megabank is convinced that by studying price charts for stocks he can make consistent profits. Act as an advocate of market efficiency and explain why you do not believe him. Another trader studies company fundamentals and claims to make consistent abnormal profits what form of the EMH does this violate? 2. According to Modigliani and Miller, what happens to cost of equity as leverage increases (and why does this happen)? 3. Corp on the Cob currently has a market value of 3.5m, with 175,000 shares outstanding and no debt. The board of directors proposes a plan to change the firms capital structure, whereby 1m of 10% irredeemable debt will be issued with the proceeds used to buy back stock. Corp on the Cob faces a 30% corporate tax rate. Calculate the new market value of the firm if the directors implement their proposed capital restructuring. To put this in perspective, also shown the old and new share price. Assume that the costs of financial distress do not change. 4. Askew Corp. has a market value of 35m and is financed solely by equity, where cost of equity is currently 20%. The directors wish to change the capital structure and are planning to issue 8m of 10% bonds. Higgins plc faces a coporate tax rate of 30%. Assume that (1) the MM assumptions hold in a world with taxes; how will replacing the equity with debt change Askews: a. Market value? b. WACC? 5. Why do agency costs arise between equity holders and bondholders? What action might bond holders take to protect themselves? 6. Barstow plc faces a cost of capital of 20%. It is a well-run business which made 25m profit last year, all of which was paid as a dividend. The directors expect profits to continue to be 25m/year for the foreseeable future. However, the directors have now identified an investment opportunity which will cost 25m and result in a pay-off in three years. This 25m would be found by not paying the dividend for one year only. What dividend would need to be paid in three years for shareholders to be indifferent between management paying out a dividend or investing? 7. A firm currently pays out the majority of its earnings as a dividend. The directors want to change this and pay out only a small dividend. Will this chance be detrimental to shareholders? Consider this in relation to MMs arguments.

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8. Read the article and associated discussion on MyTravel plc in Boakes (2010, pp. 90-93). Prepare to discuss the article and the following points in particular: a. The notion of shareholders as shock absorbers what does this mean in the case of MyTravel? b. Convertible bondholders voted on whether to accept the proposal to receive shares which effectively equal just 30% of the initial investment. Why would these bondholder vote for this? 9. Read the article and associated discussion on share buy-backs vs dividends in Boakes (2010, pp. 150-154). Prepare to discuss the article and the following points in particular: a. How do investors benefit from a share buy-back? b. Would you prefer a firm you invest in to pay you a dividend or undertake a share buy-back? 10. Read the article and associated discussion on De La Rue in Boakes (2010, pp. 155-157). Prepare to discuss the article in class and address the following questions from Boakes: a. It is often said that the dividend announcement made by a company is an important source of information about the future prospects for the business. In this case what signal is being given by De La Rue plc in the decision to raise the annual dividend by 12.4 per cent and in addition to announce a special one-off dividend of 46.5 p? b. How else could the company have used this spare cash?

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Sheet Eight


Prior to the class all students should prepare answers to the following questions: 1. Explain the three motives for firms to hold liquid reserves. Give an example to illustrate each motive. 2. Why may shareholders be concerned if the firm is holding a large quantity of cash? 3. What are the pros and cons of a liberal credit policy? What are the pros and cons of a stringent credit policy? 4. List the costs which vary directly with inventory levels and those which vary indirectly with inventory levels. 5. One definition of net working capital says it is 'the excess of current assets over current liabilities'. Another defines it as ' the component of current assets which is financed out of long-term sources'. Are these two definitions the same? Explain. 6. The Homerjay Corporation is investing in the development and initial production of a new beer flavoured doughnut. The project lasts for three years and has total outlays of 1.5m per year. The fixed transaction cost is 150 and the interest rate 5 per cent per annum. Using the Baumol model calculate the optimal amount of cash that Homerjay should withdraw. 7. What would happen to the above optimal cash withdrawal if the fixed transaction cost were to increase to 200? What would then happen if the interest rate increased to 7 per cent? 8. Nine Inch Nails Ltd needs 2.5m a year for cash outlays. The relevant short- term interest rate is 6 per cent and the fixed transaction cost for withdrawing cash is 115.50. What is the optimal size of the cash withdrawal? How often will cash be withdrawn? 9. Fatima Mansions Ltd have ordered their annual quantity of guttering. Full payment is required within 30 days, but a 2% discount is offered if the account is settled within 10 days. FMs cost of capital is 8 per cent. What should it do? 10. Green Day Drugstores Ltd. sells 2,500 boxes of an expensive drug per year. The price per box is 100, and variable inventory costs amount to 20 per cent of the price of the box. The fixed cost per order is 10. How many boxes should be ordered at a time? How many orders will be made per year?

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Formative Seminar


One of the classes in the Epiphany term will be a seminar in which you will be invited to give a 10-minute presentation on a company listed in the FTSE 100 stock index. The purpose of this is to help you to: Become used to bibliographic search Find information from electronic sources Examine company accounts Pursue independent learning

You will work in groups and each group will be given a number corresponding to the ranking of a company within the index. Your task will be to provide a general description of the company from both an economic and a financial perspective. So, you should be able to identify the market sector the company is in and explain its main activities. You should also be able to explain the important financial aspects of the company such as its share price, debt to equity ratio, dividends and earnings. You should attempt to identify five major factors (internal or external) that have had an impact on the company in the past year. You could also compare your companys performance with that of the sector and/or the market as a whole. Groups of students and the ranking number of your company, and the date of your presentation, will be allocated during the class programme. More details will be posted on DUO.

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Foundations of Finance Handbook TD

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Transcript of Foundations of Finance Handbook TD