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Examination Paper

SECTION A – Answer TWO of the following questions. Please show clearly the steps leading to your final answer.

1. Clark Industries has come up with a new prototype for a bike and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost £500,000 today. Management believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new bike.  If the test-marketing phase is successful, then Clark Industries will invest £3 million in year one to build a plant that will generate expected annual after tax cash flows of £400,000 in perpetuity beginning in year two.  If the test marketing is not successful, Clark will still go ahead with the project, but the expected annual after tax cash flows would be only £250,000 in perpetuity beginning in year two.  Kinston has the option to stop the project at any time and sell the prototype bike for £300,000.  Assume a cost of capital of 10%.

a. Determine the base case NPV of the project (30 marks)

b. What is the value of the option to sell if Clark Industries decides to sell the project in year one, assuming it becomes unsuccessful? (20 marks)

c. Assuming that Clark industries does not have the ability to sell the project for £300,000 in one year, but is able to abandon if unsuccessful. What is the NPV? (20 marks)

d. How can managers take advantage of real options? Explain. (30 marks)

2. QPR Ltd is debating whether to convert its all-equity capital structure to one that is 40 per cent debt. There are currently 2,000 shares outstanding, each with a share price of £70. Earnings Before Interest and Tax (EBIT) is expected to remain at £16,000 per year forever.  Interest rate on new debt is 8 per cent. Assume no taxes

a. Ms Jordan, a shareholder of the firm, owns 100 shares of equity. What is her cash flow under the  current capital structure, assuming the firm has a dividend payout rate of 100 per cent?  What will Ms Jordan’s cash flow be under the proposed capital structure of the firm if she were to keep all of her 100 shares?  (30 marks)

b. Suppose QPR succeeds in converting its capital structure but Ms Jordan prefers the current all-equity capital structure. Show how she could unlever her shares to recreate the original capital structure, through homemade leverage. (30 marks)

c. Based on your answer to question (b) explain why QPR’s choice of capital structure is irrelevant. (10 marks)

d. In a world with no taxes, no transaction costs, and no costs of financial distress, does moderate borrowing increase the required return on a firm’s equity? Does it necessarily follow that increases in debt increase the riskiness of the firm? Explain. (30 marks)

3. Bacchus Plc has £50 million in excess cash and no debt.  It expects to generate additional free cash flows of £40 million per year in subsequent years and will pay out these future free cash flows as regular dividends.  Bacchus’ unlevered cost of capital is 10% and there are 10 million shares outstanding.  The firm’s board is meeting to decide whether to pay out its £50 million in excess cash as a special dividend or to use it to repurchase shares of the firm's stock.

a. If Bacchus uses all of the £50 million in excess cash to pay a special dividend, what is the cum-dividend price? (25 marks)

b. Assume that Bacchus uses the entire £50 million to repurchase the shares. How many shares can be repurchased? (25 marks)

c. Assume that you own 2500 shares in Bacchus and that Bacchus uses the entire £50 million to repurchase shares.  If you are unhappy with this decision and would prefer that Bacchus used the excess cash to pay a dividend instead. How many shares will you have to sell to receive the amount of cash as if Bacchus paid you a dividend? (25 marks).  

d. Suppose you own 4000 shares of Bacchus stock and that it uses all of the £50 million to pay a special dividend. If you did not prefer to receive a dividend, how can you undo the dividend? (25 marks).

SECTION B – Answer ONE question. Be as specific as you can in the concepts you present and include examples in terms of analytical models, numerical examples and/or the world of practice.

4. Compare and contrast the efficient market hypothesis and behavioural finance. Which do you think more reflects market behaviour. Discuss. Be as specific as you can in the concepts you present and include examples in terms of analytical models, numerical examples and the world of practice. (100 marks)

5. Explain the importance of taxes in dividend policy. What are the real-world factors that would encourage firms to follow a high dividend policy? Use tools from the course and your own reading to provide relevant examples. (100 marks)

6. Managers’ motives for mergers and acquisitions are usually not consistent with the interest of shareholders. Critically discuss this statement. Use tools from the course and your private reading to provide relevant examples. (100 marks)