Department of Accounting and Finance

M.Sc. Classes

Finance I
Class Test No2

Instructions for Candidates

Answer ALL Questions (in the spaces provided)
[Failure to comply will result in papers not being marked]
Calculators must not be used to store text and/or formulae nor be capable of
communication. Invigilators may require calculators to be reset. All answers are to be
written in the spaces provided in ink. Please write clearly as illegible writing cannot be
marked. If more space is required the answer can be continued on the back of the
page where the question appears. Failure to follow these requirements will lead to a
deduction of marks.

To Be Issued: Discount Tables

To Be Completed (please write clearly)

Family Name:

Other Name:

Course (please indicate by ticking appropriate box)

M.Sc. Finance M.Sc. IAFS

For Examiners Use Only

Comments

SOLUTIONS

TOTAL MARKS
AWARDED

M.Sc. Finance (A4) 1 of 7

Q1. a) Determine the approximate value of the internal rate of return on an investment
of £6,000 that is expected to produce a single cash inflow of £11,550 in year 5.
(5 marks)

NPV = 0 = -6,000 + 11,550 1/(1 + i)5

5
(1 + i) = 11,550/6,000 = 1.925
(1 + i) = 5√1.925 = 1.13995
i = 0.14

b) Determine the approximate value of the internal rate of return on an investment

of £20,000 that is expected to produce a constant net cash flow of £6,585 for
the next four years.
(5 marks)

NPV = 0 = -2,000 + 6,585 PVAF4/i

PVAF4/i = 20,000/6,585 = 3.0372
PVAF4/0.12 = 3.0373
i ≈ 12 per cent

c) An investment of £30,000 is expected to produce a constant net cash flow in

perpetuity and offers a yield of 12 per cent whereas the required rate of return is
10 per cent. Determine its net present value and briefly interpret your answer.
(5 marks)

NPV = 30,000 = [(0.12 – 0.10)/.10] = 6,000

C = i I = 0.12 x 30,000 = 3,600
NPV = -30,000 + 3,600 1/0.10 = 6,000

As the investment is a perpetuity the net cash flow can be determine as the rate
of return times the capital outlay. The NPV can then be derived, treating the
next cash flow as a perpetuity.

d) A loan of £10,000 is to be paid off in four equal annual payments and the rate of
interest on the balance of the loan is 6 per cent (the payments cover the
repayment of capital plus interest). Determine the annual payment.
(5 marks)

Loan = PV (Repayments at the contractual rate of interest)

10,000 = X · PVAF4/.06 = X · 3.4651
X = 10,000/3.4651 = 2,886

M.Sc. Finance (A4) 2 of 7

Q2. a) Determine the payback period and the approximate value of the discounted
payback period for an investment of £20,000 that is expected to produce net
cash flows of £5,000 for the next seven years. The company’s discount rate is 8
per cent.
(5 marks)

Payback period = Outlay/Constant net cash flow

= 20/000/5,000 = 4 years

Discounted payback period

20,000 = 5,000 PVAFn/0.08
PVAFn/0.08 = 20,000/5,000 = 4,000

Use Tables – check for discount rate of 8 per cent.

The discount rate is know but the number of years is unknown.

PVAF5/0.08 = 3.9927

Approximate value is 5 years

b) Assuming that the company’s investments typically produce constant net cash
flows for seven years determine an approximate value for the maximum
payback period acceptable for an investment to produce a return of at least 8 per
cent.
(5 marks)

Let investment = 1,000

To breakeven after 7 years

1,000 = X · PVAF7/.08
1,000 = X · 5.2064
X = 1,000/5.2064 = 192.073

Maximum acceptable payback period

1,000/192 = 5.2064 years

A shorter payback period will result in a higher IRR than 8 per cent and a
positive NPV project whereas a longer payback period would indicate that the
project ‘s IRR is lower than 8 per cent.

M.Sc. Finance (A4) 3 of 7

Q3. Determine the approximate value of the modified rate of return on the following
investment in a natural resource project if outlays are required at the end of its life.
The company’s cost of capital is 12 per cent.

0 -40,000
1 14,300
2 14,300
3 14,300
4 16,600
5 -2,576
(10 marks)
Value in year 4 of the net cash flow in year 5
-2,576 1/1.2 = 2,300
Adjust value in year 4
16,600 – 2,300 = 14,300

The discounted rate of return on the adjusted net cash flows = modified rate of return

NPV = 0 = -4,000 + 14,300 PVAF4/i

PVAF4/i = 40,000/14,300 = 2.7972
PVAF4/0.16 = 2.7982 use tables (note – this is for 4 years!)

Modified rate of return ≈ 16%

Q4. Demonstrate how you can choose between the following investments to maximise
wealth using the discounted rate of return (not the net present value approach). The
company’s required rate of return is 7 per cent. Explain briefly the basis of your
analysis

0 1 2 3 4 IRR (approx)
A -10,000 3,292 3,292 3,292 3,292 12 per cent
B -16,000 5,144 5,144 5,144 5,144 11 per cent
(10 marks)

incremental 0 1–4
investment -6,000 +1,852
NPV = 0 = -6,000 + 1,865 PVAF4/i
PVAF4/i = 6,000/1,852 = 3.2397
PVAF4/0.09 = 3.2397
i* = 9 per cent > 7 per cent

As investment B can be thought of as being made up of investment A and an

incremental investment

NPV(B) = NPV(A) ± NPV (Incremental Investment)

If the NPV (Incremental Investment) is positive then

NPV(B) > NPV(A)

And the NPV of the incremental investment is positive if its yield is greater than the
required rate of return. In this case as the incremental rate of return is 9 per cent and
higher than 8 per cent required rate of return the adoption of the larger project will
maximise the firm’s NPV.
M.Sc. Finance (A4) 4 of 7
Q5. Rhoda McTaggart’s runs her own consultancy company. Her estimated net wealth is
£150,000, and she intends to retire in ten years and her annual salary after tax is
£80,000 and current expenditure is £50,000, allowing her to save £30,000 per annum.
Her pension fund advisor tells her, on the basis of actuarial evidence, that she should
plan on an expected life of 16 years following retirement. She wonders how much she
will be able to spend on an annual basis during retirement if the rate of interest she can
expect to earn on invested funds is 8 per cent, while also maintaining a minimum
wealth position of £150,000 after the expected 16 years of retirement to all for the
contingency of living longer! (Assume all cash flows occur at the end of each year)
(10 marks)
Analysis can be done in various ways – though there is only one correct answer!
Calculate the funds available at the start of retirement.

V10 = 150,000 (1 + 0.08)10 + 30,000 1/.08 ((1 + .08)10 – 1)

= 150,000 x 2.1589 + 30,000 x 14.4866
= 323,835 + 434,596
= 758,431

Resources free for pension – total funds available less present value of the sum
required at the end of the 16 year period.

V10* = 758,431 – PV (150,000)

= 758,431 – 150,000 1/(1.08)16
= 758,431 – 43,783
= 714,647

+ 714,647 = X · PVAF16/.08
714,647 = X · 8.8514
X = 714,647/8.8514
= 80,739

Q6. Fallin plc is expected to produce earnings of £36 million next year and to pay out 50
per cent in the form of dividends. Dividends are expected to grow at 6 per cent
indefinitely into the future. Investors require a rate of return of 12 per cent on
investments in companies such as Fallin. The value of the company can be
determined by using the constant rate of growth of dividends model.

a) Determine a value for the company.

(5 marks)
V0 = 36(1 – 0.5) 1/ 0.12 – 0.016 = 300
b) What rate of return is the company expected to produce on its reinvested
earnings?
(5 marks)
Growth rate = retention rate x rate of retrun
0.06 = 0.50 x i
i = 0.06/0.50 = 0.12
c) If the company’s rate of return on new investments increased to 15 per cent
while retentions remain at 50 per cent determine the increase in the value of the
company and comment on your results.
(5 marks)
*
V0 = 36(1 – 0.5) 1/(0.12 – 0.075) = 400
The increment in value comes from the present value of growth opportunities.
This is based on the assumption that 50 per cent of earnings can be re-invested
annually to earn 15 per cent. The PVGO is equal to £100m.
M.Sc. Finance (A4) 5 of 7
Q7. The price earnings ratios reported in the Financial Times for Stirling Electronics and
Resolven Electronics are 16/1and 24/1 respectively. Both companies operate in the
same industrial sector and are about the same size. Identify factors that might account
for the differences in their price-earnings ratios.
(5 marks)
The price-earnings raio can be derived from the standard valuation models:

P0 1 PVGO 1
= + = (1 − b )
E1 r E1 r − bi

The P/E ratio will be higher

• The lower the value of r.

• The greater the PVGO or the higher the value of i, and if i, is greater than r,
the higher the value of b (the retention ratio).

Difference in r between the two companies are not likely to be significant if they are
drawn from the same industry unless they have difference levels of gearing. (This
observation could not be expected on the basis the Finance I material!)

The primary differences are most likely to arise because of the differences in growth
opportunities – with Resolven having more opportunities than Stirling.

The differences could arise in part from differences in accounting policies, eg.
Resolven might be writing off its assets (higher depreciation charges) more rapidly
than Stirling, thereby decreasing earnings and increasing the price-earnings ratio.
(But accounting differences alone are unlikely to explain all of such a wide gap in the
price earnings ratio. To the extent that differences in accounting policies can explain
in part differences in price-earnings ratios it is assumed that the stock market
recognise the impact of variations accounting policy and this does not have any affect
on the share prices.)

Another possibility is the earnings of Resolven may be temporarily low. If the low
level earnings is not expected to be maintained the price will fall less than earnings,
thereby pushing up the price-earnings ratio.

M.Sc. Finance (A4) 6 of 7

Q8. Friction plc is considering replacing some stacking equipment. The existing
equipment was bought six years ago for £400,000 and is still in good working order
and it could be used for another ten years. It is being depreciated for tax purposes on
a straight line basis over an assumed working life of ten years. If it is replaced now it
could be sold for scrap for £30,000, but if it is used for another ten years it would
have little or no value. The new equipment is much more efficient and would reduce
operating costs by £120,000 per annum. It would cost £600,000, has an estimated
working life of ten years and would be depreciated for tax over this time period on a
straight line basis. A residual value of £50,000 is anticipated after ten years use.
Determine the NPV of the investment if the required rate of return is 8 per cent and
the tax rate is 40 per cent? (Set out all your calculations!)
(10 marks)

Profit and Loss 0 1–4 5 – 10 10

Capital Loss (OM) -130
Capital Gain (NM) 50
Cost Savings 120 120
Change in Depreciation (20) (60)
Change in Profit -130 100 60 50
Change in Tax 52 (40) (24) (20)

Net Cash Flow 0 1–4 5 – 10 10

Recovery Value (OM) 30
Investment (600)
Recovery Value 50
Cost Savings 120 120
Change in Tax 52 (40) (24) (20)
NCF (518) 80 96 30
PVF 1.0000 3.3121 3.3980 0.4632
NPV 87.07

Q9. A firm is considering two investments that require the same outlay and both produce
rates of return above the minimum acceptable rate of 8 per cent. The first is expected
to produce constant net cash flows for four years and offers a yield of 14 per cent.
The second is also expected to produce a constant net cash flow but for six years.
This second investment offers a rate of return of 12 per cent. Which investment
produces the highest net present value? Demonstrate how your answer was obtained.

Set the investment equal to some arbitrary value – it will not affect relative sizes of
the NPVs for the two investments. An investment of £1,000 is easy to deal with but
the analysis could equally as well have been done with £1.

NPV = 0 = -1,000 + X · PVAF4/.14 = -1,000 + X1 2.9137

X1 = 343
= -1,000 x PVAF6/0.12 = -1,000 + X2 · 243

NPV = -1,000 + 343 x PVAF4/.08 = -1,000 + 343 x 3.3121 = 136

= -1,000 + 243 x PVAF6/.08 = -1,000 + 243 x 4.6229 = 123
The shorter life investment offers the highest NPV
(10 marks)
TOTAL 100 MARKS
End of Paper

M.Sc. Finance (A4) 7 of 7