ACFI3203 Business Finance 2023/24Haskell

Java Python Business Finance – ACFI3203 2023 520

2023/24

SECTION A – SHORT FORM. QUESTION

Answer all questions in this section

QUESTION 1: CAPITAL STRUCTURE

Critically discuss various sources of capital (debt vs. equity) that companies can utilise to raise funds for their operations and expansion. Focus on evaluation of the advantages and disadvantages associated with each source of funding, considering the implications for long-term financial sustainability. (10 marks) 

SECTION A TOTAL 10 MARKS 

Section B

Choose ONE (1) question only from this section. (ie Question 2 OR Question 3)

QUESTION 2: NPV (Net Present Value)

Introduction:

Virgin Media, a leading telecommunications company, is considering a substantial investment in a new next generation connection technology.

This investment, backed by comprehensive research that incurred costs of £300,000, holds the potential to attract a significant number of new customers and may be extended to other European countries. However, before proceeding with the project, Virgin Media needs to evaluate its financial feasibility and assess its potential for generating value for the company.

Investment in New Machinery:

The heart of this project is the acquisition of new machinery with an initial cost of £450,000. This machinery is expected to have a useful life of 6 years and a residual value of £120,000 at the end of its lifespan. Virgin Media plans to claim tax depreciation allowances at a rate of 25% on a reducing balance basis until the year of disposal when a balancing allowance will arise. Tax depreciation allowances are received in arrears.

Revenue and Cost Projections:

Revenue projections for this project are critical for evaluating its financial viability. Virgin Media forecasts revenue of £50,000 in the first two years, followed by a substantial increase to £200,000 per year in years 3, 4, and 5, and a further jump to £300,000 in the final year. These projections are in real terms and do not take into account an annual inflation rate of 6%.

Costs are forecast to be £35,000 p.a. in real terms.

Cost of Capital:

Virgin Media's cost of capital is a crucial factor in evaluating the project's attractiveness. The firm's real cost of capital is 9% per annum.

Tax Implications:

Tax considerations play a pivotal role in assessing the financial viability of the project. With a tax rate of 30%, Virgin Media needs to account for the tax implications of the project's revenues and expenses. Tax payments occur in the year following the profit realisation.

Required:

Virgin Media must employ various financial evaluation methods to make an informed decision regarding the new next generation connection investment. The following financial metrics should be considered:

a) Use the Net Present Value (NPV) method (including inflation and taxation) to evaluate and decide whether the new product should be undertaken.     (30 marks)

b) Use the Payback Period method to determine how long it will take to recover the initial investment from the project's cash flows. Consider the machinery investment and projected revenue only, ignore the yearly costs and inflation.   (5 marks)

c) Critically discuss the differences between NPV and IRR methods that can be used in the project appraisal decision making process.    (10 marks) 

TOTAL: 45 Marks

Choose ONE (1) question from this section (ie Question 2 OR Question 3)

QUESTION 3: RISK AND RETURN

Associated British Foods Plc, the owner of Primark, has identified a new project aimed at increasing shareholder value and enhancing brand visibility. The proposed project involves opening a coffee shop within the main Primark store in London. The total investment required for this venture is £400,000. The success of this project depends on market reception and customer demand.

There is an 80% chance that the product launch will be successful, and a 20% chance that it will fail. If it is successful, the levels of expected profits before the impact of the investment and the probability of each occurring have been estimated as follows, depending on whether the coffee shop popularity is high, medium or low:

Popularity	Probability	Profit £
High	30%	600,000
Medium	60%	300,000
Low	10%	200,000

If it is a failure, there is a 60% probability that the coffee shop’s machinery and furniture can be sold for £150,000 and a 40% probability that it will be worth nothing at all.

You are a financial analyst advising the board of Associated British Foods Plc on whether to proceed with the coffee shop project in the Primark store in London. To make an informed decision, you need to assess the financial viability and potential risks associated with the project:

Requirements:

Evaluate the proposal and calculate the expected value for this project.   (10 marks)

Calculate the proposal’s risk using the standard deviation method.    (20 marks) 

Given the financial analysis and risk assessment, provide a clear recommendation to the board of Associated British Foods Plc on whether to proceed with the coffee shop project. Justify your recommendation based on the information provided and any additional insights you believe are relevant.    (5 marks) 

Discuss the importance of conducting a sensitivity analysis to assess this project's sensitivity to variations in key parameters, such as the probability of success and the initial investment cost.    (10 marks) 

TOTAL: 45 marks

Section C

Choose ONE (1) question only from this section. (ie Question 4 OR Question 5)

QUESTION 4: DIVIDEND POLICY

You are a financial analyst tasked with advising the board of directors of Tesco Plc on their dividend policy. Tesco Plc has been considering adopting either a residual dividend policy or a smooth dividend policy. The company has just received the forecasted cash flows from operating activities (after interest and taxation) for the next six years as follows:

< ACFI3203 Business Finance 2023/24Haskell table class="MsoNormalTable ke-zeroborder" border="0" cellspacing="0" >

Year

CF(£m)

1

3.8

2

7.3

3

7.8

4

6.3

5

7.5

6

6.9

All cash flows have been calculated before the deduction of additional investment in fixed capital. According to the chief accountant, the latest figures for the additional investments amounts to £1.1 million in each of the first two years and £2.8 million for each year thereafter. The firm currently has a cash balance of £2,400,000 which it intends to double to cope with unexpected events, the growth in the cash balance will be spread evenly over the 6 years.

Tesco currently has 9.8 million shares issued and is committed to shareholders' wealth maximisation.

As part of your analysis, you need to evaluate the requirements below:

Requirements:

Tesco is committed to maximising shareholders' wealth. As a financial analyst, critically evaluate the potential advantages and disadvantages of Tesco adopting residual vs smooth dividend policy. Consider the impact on shareholders' wealth in your analysis.   (8 marks) 

Based on the information provided, how might Tesco's management determine an appropriate dividend policy? Critically discuss the factors they should consider when making decisions about the amount and timing of dividend payments.   (7 marks) 

Given the commitment to shareholders' wealth maximisation and the information provided, propose and calculate the residual dividend policy recommendation for Tesco for the next 6 years.   (12 marks) 

Using the smoothing approach, what are the dividends per share and total dividends that will be paid out? In your calculation you are required to consider and calculate the possibility to pay out special dividends.   (18 marks) 

TOTAL: 45 Marks

Choose ONE (1) question only from this section. (ie Question 4 OR Question 5)

QUESTION 5: CAPM (Capital Asset Pricing Model)

You are an investment analyst at an UK financial advisory firm, and your client is considering investing in Tesla Plc. Your task is to evaluate the data below and provide insights into the implications of your findings.

The current share price of Tesla Plc is 550p. It’s reported earnings per share of 27p and the financial history of the firm is as follows:

Tesla Plc Data:
Time	Dividends	Return	Market Return
Last reported	27p	18%	16%
One year ago	25p	10%	12%
Two years ago	18p	11%	15%
Three years ago	15p	9%	13%
Four years ago	13p	7%	14%
Five years ago	10p	-2%	6%

The rate of growth in earnings and dividends shown in the past is expected to continue into the future.

The risk-free rate of return is 7.5 per cent and the risk premium on the average share has been 7 per cent for decades.

Requirements:

a) Calculate the current dividend yield.   (5 marks) 

b) Using the Tesla’s return calculate the β of the shares. Explain what beta represents in the CAPM framework and calculate the required rate of return (expected return) for this share using the CAPM formula.  (25 marks) 

c) Calculate whether the shares at 405p are over- or under-priced. You may use DVM model (growth rate) formula and compare it to CAPM.  (5 marks) 

d) Given that your client already has a well-diversified portfolio. Discuss how adding this asset to the existing portfolio might impact the overall risk and return characteristics of the portfolio. Critically explain what are the main problems with CAPM