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2019 EXAMINATIONS
Part II (SECOND AND FINAL YEAR)
ACCOUNTING AND FINANCE
Ac.F263 INTRODUCTION TO FINANCE
(2 HOURS PLUS 15 MINUTES READING TIME)
________________________________________________________________
This examination paper consists of four questions, each worth 50 marks.
Answer only TWO questions (one from Section A and one from Section B).
For each question, please write your answers in a separate booklet.
A formula sheet is attached to the examination paper.
The use of standard calculators with scientific, and standard arithmetic and statistical
functions, is permitted.
________________________________________________________________
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SECTION A
SECTION A CONSISTS OF QUESTIONS 1 AND 2.
ANSWER ONLY ONE QUESTION FROM SECTION A (EITHER QUESTION 1 OR QUESTION 2).
QUESTION 1
ANSWER ALL PARTS OF THIS QUESTION
a. GetFair plc is not expected to pay dividends in the next four years. In year 5, it is expected to
pay a dividend of ￡3 per share. Dividends are expected to be maintained at this level for the
foreseeable future thereafter. Assume investors require a return of 8 per cent. What is each
of GetFair shares currently worth
[6 marks]
b. Macrosoftware plc is a young start-up company. No dividends will be paid on its stock over
the next 7 years because the firm intends to reinvest all its earnings to generate growth. The
company will then pay a ￡1 per share dividend in year 8 and will increase the dividend by 4
per cent per year thereafter. If the required return on this stock is 9 per cent, what is the
current share price
[8 marks]
c. Castlebank plc is trading at ￡51.25 per share. The stock currently pays a dividend of ￡2.50
per share. Assuming that the expected growth in dividends will be 5% a year forever,
estimate the return that you can expect to make as an equity investor in this stock.
[6 marks]
d. What is the value of a share in a company that currently pays out ￡1.00 per share in dividends
and expects these dividends to grow at 15 per cent a year for the next 5 years and 6 per cent
a year forever after that (You should assume that investors require 12.5 per cent return on
stocks of equivalent risk.)
[10 marks]
e. Compare and contrast the characteristics of common stocks and preferred stocks.
[10 marks]
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f. Briefly explain the dividend discount model used for the valuation of common stocks.
[5 marks]
g. Discuss the limitations of the Gordon Growth model for the valuation of stocks.
[5 marks]
TOTAL 50 MARKS
4
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QUESTION 2
ANSWER ALL PARTS OF THIS QUESTION
a. You have valued a British consol (perpetual bond) at ￡636. Assuming that the coupons are
paid semi-annually and that the interest rate on risk-free government bonds is 6% per annum,
estimate the annual coupon on this bond.
[3 marks]
b. You buy a 10-year zero-coupon bond, with a face value of ￡1,000, for ￡300. What rate of
return will you make on this bond, assuming you hold it until maturity
[5 marks]
c. What is the value of a 15-year corporate bond, with the coupon rate of 9%, if current
interest rates on similar bonds are 8%
[8 marks]
d. You take out a three-year loan for ￡15,000. The loan requires equal annual payments and the
interest rate is 10 per cent.
REQUIRED:
i. Calculate the equal annual payment required.
[5 marks]
ii. Prepare an amortisation schedule for the loan repayments. How much interest will you
pay in total over the life of the loan
[10 marks]
e. Explain interest rate risk and how it affects bonds.
[7 marks]
f. Compare and contrast the valuation of common stocks with corporate bonds.
[12 marks]
TOTAL 50 MARKS
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SECTION B
SECTION B CONSISTS OF QUESTIONS 3 AND 4.
ANSWER ONLY ONE QUESTION FROM SECTION B (EITHER QUESTION 3 OR QUESTION 4).
QUESTION 3
ANSWER ALL PARTS OF THIS QUESTION
a. Happy Birds plc is considering investing into a new 5-year project after a feasibility research
that cost the company ￡50,000 last month. Based on the research, the project is estimated to
generate ￡600,000 in annual sales with costs of goods sold of ￡200,000. In addition to this
variable cost, there are relevant general & administration expenses of ￡20,000 each year for
the project. This project requires an initial capital spending on a machine that costs ￡1 million
immediately and the company’s accounting department suggests that it is appropriate to
depreciate this machine in a straight line over its five-year life to a zero salvage value for
accounting and tax purpose. ￡25,000 working capital is required at the beginning of the
project and the full amount of working capital will be recovered when the project terminates.
Given the risk of the project, the appropriate cost of capital is 15% and the company pays a
corporate income tax of 40%.
REQUIRED:
i. What are the project’s free cash flows
[15 marks]
ii. Calculate the NPV of this new project and briefly explain the implications of the NPV
calculated for the firm’s shareholders.
[10 marks]
iii. Briefly discuss any potential drawbacks to the NPV method.
[5 marks]
iv. Calculate the payback period of this new project.
[5 marks]
v. Briefly discuss any potential shortcomings of the payback period rule.
[5 marks]
b. Discuss the advantages and disadvantages of Average Accounting Return (AAR) as an
investment criteria.
[10 marks]
TOTAL 50 MARKS
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QUESTION 4
ANSWER ALL PARTS OF THIS QUESTION
a. Suppose that the market estimates that Stock A and B have the following expected returns
under five different states of economy, with their corresponding likelihoods.
State of
Economy
Probability of
State of
Economy
Stock A Stock B
Boom 5% 50% -5%
Optimistic 20% 25% 2%
Normal 50% 15% 8%
Pessimistic 20% 5% 10%
Recession 5% -20% 12%
REQUIRED:
i. Calculate the expected return and standard deviation of the two assets.
[10 marks]
ii. Calculate the expected return and standard deviation of a portfolio consist of 40% in
Stock A and 60% in Stock B.
[5 marks]
iii. Briefly explain why the above portfolio has lower risk than the individual stocks used
to construct the portfolio.
[5 marks]
b. Anaconda Inc has a beta of 0.8 and an expected return of 15% while Python Corp has a beta
of 1.2 and has an expected return of 20%. Assume that the CAPM holds and these assets are
correctly priced according to their risk.
REQUIRED:
i. Based on CAPM, what is the expected market return
[10 marks]
ii. Suppose that a portfolio that consists of Anaconda Inc and Python Corp with equal
weights has an expected return of 17%. Is this portfolio over-priced or under-priced
What will happen to this portfolio in the presence of this mis-pricing
[5 marks]
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c. Rain Droplets Technologies, a leading social media company, has just paid a dividend of ￡5 per
share. The company’s equity is valued at ￡60 per share based on a forecast that the company’s
dividends will increase at a constant rate of 5%. Suppose that Rain Droplets has a debt-to_x005f equity ratio of 0.8 and its pre-tax cost of debt is 8%. The company pays corporate tax at 40%.
REQUIRED:
i. Determine Rain Droplets’ cost of equity using the dividend growth model.
[5 marks]
ii. Briefly discuss the potential drawbacks of the dividend growth model.
[5 marks]
iii. Calculate the company’s weighted average cost of capital (WACC).
[5 marks]
TOTAL 50 MARKS
8
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FORMULA SHEET (all notations/symbols are standard)
Present value of a single cash flow:
= (1

+

)
Present value of annuity:
=
1 (1 +
1
)
Present value of annuity due:
=
1 (1 +
1
) × (1 + )
Future value of annuity:
= ×
(1 +

) 1

Effective annual rate:
= 1 +

1
Present value of perpetuity/Consol bond/Zero growth dividend stock:
=

Bond price: =
(1 + ) + (1 +

)

=1
=
1 (1 +
1
) + (1 +

)
9
END OF PAPER
Constant growth dividend model:
= +1

Operating Cash Flow (OCF):
= + Taxes =
= ( ) ( ) × =
= ( )(1 ) + ×
Capital Asset Pricing Model:
( ) = + ( )
Covariance and Correlation:
cov = =

( ) ( )
= cov

WACC:
= + (1 ) +
End of formula sheet.