Question 1 TUTOR TALK: As a starting point for your research, using library sources and the Internet, the following book contains an interesting series of articles on the subject: Kamphuis Jr R M et al. (eds.) (1989) Black Monday and the Future of Financial Markets, Homewood, IL: Dow Jones-Irwin. On Monday, October 19, 1987, the Dow Jones industrial index fell 23%, followed by a sharp decline in share prices world-wide. Immediately after the fall, the main question was: do security prices really reflect their fundamental values? If not, the EMH would be another casualty of the crash with important implications for those financial managers who believed that securities are fairly priced and that it is difficult to beat the market. With the benefits of hindsight, what explanation can an EMH theorist offer for the crash of 1987? What do the events that preceded it tell us about investor behaviour? Question 2 You are a risk-averse investor considering an investment that requires an initial outlay of ?50,000. You have calculated the present values of the future distribution of gains and losses, their associated probabilities, as well as their equivalent utilities based upon a personal utility function that conforms to Figure 2.5. The summarised data is as follows: Cost Discounted gains and losses ?000s (50) 200 100 50 (10) (15) Probability 1.0 0.1 0.3 0.4 0.1 0.1 Utility 0.65 1.67 1.00 0.65 (0.75) (1.52) Using the concept of expected monetary value (EMV), would you accept the investment based upon its E(NPV)? Question 3 How does your answer compare with a decision using the present value of the cash flows of your expected utilities drawn from Figure 2.5? Question 4 Do you think mean variance analysis would alter your final choice? You need not calculate the standard deviation. Just write down a brief explanation of what it has to offer. Question 5 Technotronic Ltd currently requires payment from customers by the month end after the month of delivery (45 days). On average, it takes them 87 days to pay. Sales amount to ?2 million per year and bad debts to ?40,000 per year. It is planned to offer customers a cash discount of 2% for payment within 30 days. Technotronic estimate that 50% of customers will accept this facility but the remainder will not pay until 80 days after the sale. At present, the company has an overdraft facility costing 10% per annum. If the plan goes ahead bad debts will fall to ?20,000 per annum and there will be savings in credit administration of ?10,000 per annum. Should Technotronic offer the new terms to customers? Question 6 The UK capital market has experienced one of the most volatile periods in its entire history. Over recent years, the index of Britain?s highest valued companies, the FTSE-100, has often moved up and down by more than 100 points in a single day, driven by the extreme price fluctuations of risky Internet or technology shares and a decline in the value of blue-chip companies. Consequently, conventional methods of assessing stock market performance, such as dividend yield, dividend cover, EPS and P/E ratio, as well as the assumptions upon which they are based, are now questioned by professional analysts and academics. Many IT firms have never shown a profit or paid any dividends, but their share prices can still soar. Many traditional companies have also suffered from being unfashionable, and despite creditable financial performance their values can plummet. In March 2000, a radical shake-out of the FTSE-100 occurred: many well-known companies that provide millions of consumers with essential goods and services, including utilities, were dropped and replaced by little-known firms, valued more on hope rather than expectations. In terms of trading fundamentals, the nine new companies made a total profit of ?500 million, against ?3.73 billion by the companies they replaced. The new entrants also employed far fewer people. For example, Baltimore?s staffing was 500, compared with Whitbread?s 98,000. FTSE-100 adjustments: March 2000 Robert Shiller, in his recent book, Rational Exuberance identifies investors who act in unison but not necessarily rationally. Market sentiment gains a momentum, unsubstantiated by any underlying corporate profitability or significant economic events (like 1987) that is impossible to unscramble, as more individuals wait to sell or buy at a certain price. When some psychological barrier is breached, price movements in either direction can be triggered and a crash or rally may ensue. If, as Shiller concludes, Wall St is a place to avoid, the questions we must ask ourselves are how and when can investors beat the market? Chartists who subscribe to the market?s ?weak? form hypothesis believe that a mathematical study of past share prices reveals cyclical patterns, which hold the key to all future market movements. The problem today is that by the time chartists spot a trend, it may have already passed them by and a crash or rally could be underway. Without access to insider information, can you suggest any alternative strategies for selecting profitable shares when prices fluctuate dramatically? Your answer should be based on public announcements such as dividend or profit expectations, other corporate and market information (EMH in its semi-strong form, see Unit 1). You do not need to use complex mathematical formulae, but rather common-sense, complementary analyses to improve your chances of coming out ahead in a volatile market. Question 6 We have considered the theoretical and empirical relevance of dividend policy for share valuation; now let us apply our knowledge to what is perhaps the most important strategic business decision that a corporate financial manager is ever likely to encounter: the acquisition of one company by another as a going-concern in the event of a takeover. We assume that the motives underpinning the acquisition are rational. As the predator, your company has completed a thorough analysis of its strategic capabilities and decided upon a potential acquisition as the most viable means of achieving its objectives. Within the context of financial management, these are defined in terms of maximisation of shareholders? wealth. However, questions arise as to what bid price will be acceptable and how to calculate it? We are also concerned about post-acquisition success. If an acquisition is not part of a carefully conceived corporate plan, management will have problems that will be passed on to shareholders and potential investors alike. As a consequence, their expectations may not be fulfilled. Confidence can evaporate rapidly and the initial equity price will tumble. Assume that in determining the takeover bid, careful attention has been given to the history of both companies and their present positions. The following information, including predatory data, is available in relation to a valuation date of December 2000. The target assets, profits and hence real dividend pay-out percentages are valued using current costs, rather than historical cost accounting procedures. Wherever possible, post-tax earnings are cash-flow based. For example, a non-cash expense such as depreciation has been added back to post-tax profits. Your company, DVD plc, is an electronics manufacturer. It regards the acquisition of Modem plc as an ideal opportunity for expanding its distribution network. The data overleaf has been placed before your Executive Board for consideration: a. 31.12.2000: adjusted balance sheet of Modem plc (? million) Share capital (fully paid) 200 Reserves 80 280 Represented by: Fixed assets 160 Net Current assets 120 280 a. Modem?s record of adjusted earnings before tax (EBIT) and dividend pay-outs Year EBIT (? million) Dividend (%) 1998 28 50 1999 32 50 2000 36 60 a. Investment and financial criteria of DVD plc 1. The bid will be made as soon as possible. Thereafter, the accounting year end will coincide with the end of the calendar year. 2. The marginal cut-off rate for investment is 13%. 3. After takeover, Modem?s EBIT is expected to be ?40 million for the year ending 31.12.2001, subsequently rising at an annual compound rate of 5%. 4. The forecast dividend pay-out ratio will absorb 80% of profits after corporation tax at 25%. 5. There will be an immediate asset revaluation loss of ?4 million, but an exceptional distribution of ?52 million to shareholders contingent upon a realisation of assets surplus to requirements, post acquisition, on 31.12.2001. Asset replacements are not foreseeable. 6. The anticipated dividend capitalisation rate is expected to be 15% to compensate for the financial risk associated with the pay-out ratio. On behalf of DVD plc, you are requested by the Chief Executive to calculate possible offer prices for all of the share capital of Modem using DCF techniques. Question 7 You are the financial manager of a major plc and you have recently read some comments in the financial press on the Stern Stewart model. Explain in simple terms, perhaps with the help of a diagram, how their model relates to your corporate function. Question 8 Read Myers? original article by Resource Item 8.1 and see what it offers the financial manager. Then consider whether any of the approaches support current thinking, as evidenced by the Stern-Stewart model of financial behaviour and value (Unit 6). If they do, fine; if not, we have a problem. Like MM, future academics must return to first principles and produce a better theory before offering advice to financial managers and the investment community. What type of risk are MM talking about? Question 9 How does risk affect management? Question 10 How does capital structure affect the cost of capital according to Propositions I and II? Question 11 In this final unit review activity, we put theory into practice and illustrate how the CAPM based on MM?s view of the world compares with the mean-variance analysis that we first encountered in Unit 2. Consider the following scenario: The executive board of the Demont Company is discussing the feasibility of new investments similar to their existing portfolio. In the presence of capital rationing, a choice has to be made between two mutually exclusive projects with immediate set-up costs of ?10 million each. The market currently values the company at ?100 million. The risk-return profile of its existing activities per ? of market value conforms to the characteristics of the stock market as a whole. The prevailing rate of interest on gilt-edged securities is 10% per annum. As the company?s Finance Director, you believe that, depending on probability estimates for the future state of the economy, the returns from existing activities and the respective net cash inflows of each project (including their residual value) one year hence should equal: State of economy 1 2 3 Probability 0.3 0.4 0.3 ?m ?m ?m Current portfolio 90.0 120.0 130.0 Project A 10.0 11.75 13.0 Project B 12.5 12.5 9.5 Question 12 You are therefore asked by the CEO to explain the consequences of this forecast showing which, if either, of the new investment proposals should be accepted. To keep matters simple, ignore inflation and taxation. Question 13 In your own words summarise the major learning points from the whole of your study programme with particular reference to: • Introduction to financial management • Capital investment appraisal • Working capital management • Equity valuation, stock market data and investment • Dividend decision and valuation of corporate equity • Cost of capital, corporate investment and market valuation • Financial policy and capital structure • Portfolio decision and risk management Question 14 With reference to your own learning summarise how you will be able to utilize these theories when working in an everyday situation.
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