bmmf5103 - answer scheme exam july 2012

8/10/2019 BMMF5103 - Answer Scheme Exam July 2012

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MARKING SCHEME BMMF5103/JULY2012/F-AA

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JULY 2012MARKING SCHEME BMMF5103 - MANAGERIAL FINANCE

Suggested Answers:

PART A

Question 1

a) The standard deviation of a distribution of asset returns is an absolute measure ofdispersion of risk about the mean or expected value. A higher standard deviation indicatesa greater project risk. With a larger standard deviation, the distribution is more dispersedand the outcomes have a higher variability, resulting in higher risk. The coefficient ofvariationis another indicator of asset risk, measuring relative dispersion. It is calculated bydividing the standard deviation by the expected value. The coefficient of variation may be abetter basis than the standard deviation for comparing risk of assets with differing expectedreturns.

b) The correlation between asset returns is important when evaluating the effect of a new

asset on the portfolios overall risk. Returns on different assets moving in the samedirection are positively correlated, while those moving in opposite directions are negativelycorrelated. Assets with high positive correlation increase the variability of portfolio returns;assets with high negative correlation reduce the variability of portfolio returns. Whennegatively correlated assets are brought together through diversification, the variability ofthe expected return from the resulting combination can be less than the variability or risk ofthe individual assets. When one asset has high returns, the others returns are low and viceversa. Therefore, the result of diversification is to reduce risk by providing a pattern ofstable returns. Diversification of risk in the asset selection process allows the investor toreduce overall risk by combining negatively correlated assets so that the risk of the portfoliois less than the risk of the individual assets in it. Even if assets are not negativelycorrelated, the lower the positive correlation between them, the lower the resulting risk.

c) The security market line (SML) is a graphical presentation of the relationship between theamount of systematic risk associated with an asset and the required return. Systematic riskis measured by beta and is on the horizontal axis while the required return is on the verticalaxis.

(i) inflation: If there is an increase in inflationary expectations, the security market line willshow a parallel shift upward in an amount equal to the expected increase in inflation.The required return for a given level of risk will also rise.

(ii) risk tolerance: The slope of the SML (the beta coefficient) will be less steep if investorsbecome less risk-averse, and a lower level of return will be required for each level ofrisk.


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PART B

Question 1

a) Future value(FV), the value of a present amount at a future date, is calculated by applyingcompound interest over a specific time period. Present value (PV), represents the dollarvalue today of a future amount, or the amount you would invest today at a given interestrate for a specified time period to equal the future amount. Financial managers preferpresent value to future value because they typically make decisions at time zero, before thestart of a project.

b) The nominal annual rateis the contractual rate that is quoted to the borrower by the lender.The effective annual rate, sometimes called the true rate, is the actual rate that is paid bythe borrower to the lender. The difference between the two rates is due to the compoundingof interest at a frequency greater than once per year. The effective annual rate increaseswith increasing compounding frequency. The nominal and effective rates are equivalent forannual compounding. The effective rate of interest differs from the nominal rate of interest

in that it reflects the impact of compounding frequency. The nominal rate is more preferredas the interest is being compounded only once a year as opposed to the frequentcompounding in the effective rate.

c) Bank A: n 4, i 9%, m 1FV 5,000(1.412) $7,060

Bank B: n 4, i 8%, m 2FV 5,000(1.369) $6,845

Jamilah should deposit her money in Bank A and she will have $7,060 upon hergraduation from college.

d) PMT 3,500,000/2.487 $1,407,318.05

Year Payment Principal Interest Balance

0 0 $3,500,000.00

1 $1,407,318.05 $1,057,318.05 $350,000.00

2,442,681.95

2 1,407,318.05 1,163,049.85244,268.20

1,279,632.10

3 1,407,318.05 1,279,354.84127,963.21


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e) First determine the price of the chalet in 5 years:

FV = PV(1 + i)n

= RM250,000(1.05)10

= RM250,000(1.6289)

= RM407,223.66

Next, determine the annual end-of-the deposit based on the ordinary annuity formula,given:

FVA = RM407,223.66; I = 13%; n = 10.

Therefore, A = RM407,223.66/18.4198 = RM22,108

Question 2

a) Common stockholders are the true owners of the firm, since they invest in the firm onlyupon the expectation of future returns. They are not guaranteed any return, but merely getwhat is left over after all the other claims have been satisfied. Since the common

stockholders receive only what is left over after all other claims are satisfied, they areplaced in a quite uncertain or risky position with respect to returns on invested capital. As aresult of this risky position, they expect to be compensated in terms of both dividends andcapital gains of sufficient quantity to justify the risk they take.

b) Rights offerings protect against dilution of ownershipby allowing existing stockholders topurchase additional shares of any new stock issues. Without this protection currentshareholders may have their voting power reduced. Rightsare financial instruments issuedto current stockholders that permit these stockholders to purchase additional shares at aprice below the market price, in direct proportion to their number of owned shares.

c)ks 0.12 1.50(0.18 0.12)

0.21

= +

=

growth rate of dividends:

2.23/2.10 FVIF1.105 5%

$2.45Po $15.31

0.21 0.05= =

d)

t Do FVIF5%,t Dt PVIF8%,t PV1 $2.00 1.050 $2.10 0.926 $1.94

2 2.00 1.102 2.20 0.857 1.89

3 2.00 1.158 2.32 0.794 1.84

4 2.00 1.216 2.43 0.735 1.79

P1 $7.46


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D52.43 (10.03) $2.50

2.50 1P2 $36.75

0.08 0.03 (1 0.08) ^4= =

+

Value of stock $36.75$7.46 $44.21

e) Equity capitalis permanent capital representing ownership, while debt capitalrepresentsa loan that must be repaid at some future date. The holders of equity capital receive aclaim on the income and assets of the firm that is secondary to the claims of the firmscreditors. Suppliers of debt must receive all interest owed prior to any distribution toequity holders, and in liquidation all unpaid debts must be satisfied prior to anydistribution to the firms owners. Equity capital is perpetual while debt has a specifiedmaturity date. Both income from debt (interest) and income from equity (dividends) aretaxed as ordinary income. To the corporation, debt interest is a tax deductible expensewhile dividends are not.

Question 3

a) The current ratio proves to be the better liquidity measure when all of the firms currentassets are reasonably liquid. The quick ratio would prove to be the superior measure if theinventory of the firm is considered to lack the ability to be easily converted into cash.

b) The owners are probably most interested in the Return on Equity (ROE) since it indicatesthe rate of return they earn on their investment in the firm. ROE is calculated by takingearnings available to common shareholder and dividing by stockholders equity.

c)Sales 3060

-COGS 1800

GP 1260

-opex 600

EBIT 660

-int 126

EBT 534

-tax(40%) 213.6

NI 320.4

-pfd divd 18NI Cmn 302.4

# of Cmn 1000

EPS 0.30


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d) Sales CGS/(1 GPM) 105,000/(1 0.30) $150,000

Total Assets Sales/(Total Asset Turnover)

150,000/0.50 $300,000

Net Profits After Taxes (ROA) (Total Assets)

(0.02)

(300,000)

$6,000

e) Equity = RM1,500,000 RM750,000 = RM750,000.

ROE = NI / OE = RM30,000/ RM750,000 = 4 percent.

Question 4

a) A bond sells at a discount when the required return exceeds the coupon rate. A bond sellsat a premiumwhen the required return is less than the coupon rate. A bond sells at par

value when the required return equals the coupon rate. The coupon rate is generally a fixedrate of interest, whereas the required return fluctuates with shifts in the cost of long-termfunds due to economic conditions and/or risk of the issuing firm. The disparity between therequired rate and the coupon rate will cause the bond to be sold at a discount or premium.

If the required return on a bond is constant until maturity and different from the couponinterest rate, the bonds value approaches its $1,000 par value as the time to maturitydeclines.

b) Liquidity problems exist in thinly traded bonds, default risk is the likelihood the corporationwill default on its bond obligations, and the maturity premium reflects the fact that longer-term bonds possess greater interest rate risk and sensitivity than shorter term bonds. If any

of these exist, investors will demand to be compensated for the risk by demanding a yieldpremium to own the bonds.

c) Per piece: PV = RM1,000(1/(1+0.07)20)

= RM258.42

For 20 pieces: Price = 60 x RM258.42 = RM15,505.14.

d) Approx. YTM = [INT + {(Par Price)/N}] / {(Par + Price)/2}

= [150 + {(1,000 1,250)/10}] / {(1,000 + 1,250)/2}

= 125/1125 = 11.11%

Calculator: YTM = 10.79%


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e) Bond E will have a greater change in price because it has a longer maturity date whichexposes itself to greater risk due to longer period of uncertainty.

Question 5

a) The equation for the Capital Asset Pricing Model is:

kjRF[bj(kmRF)],

where:

kj the required (or expected) return on asset j.RFthe rate of return required on a risk-free security (a U.S. Treasury bill)bj the beta coefficient or index of nondiversifiable (relevant) risk for asset jkmthe required return on the market portfolio of assets (the market return)

The CAPM provides financial managers with a link between risk and return. Because it wasdeveloped to explain the behavior of securities prices in efficient markets and useshistorical data to estimate required returns, it may not reflect future variability of returns.While studies have supported the CAPM when applied in active securities markets, it hasnot been found to be generally applicable to real corporate assets. However, the CAPMcan be used as a conceptual framework to evaluate the relationship between risk andreturn.

b) The efficient market hypothesis says that in an efficient market, investors would buy anasset if the expected return exceeds the current return, thereby increasing its price (marketvalue) and decreasing the expected return, until expected and required returns are equal.

According to the efficient market hypothesis:

(a) Securities prices are in equilibrium (fairly priced with expected returns equal to required

returns);(b) Securities prices fully reflect all public information available and will react quickly to new

information; and

(c) Investors should therefore not waste time searching for mispriced (over- orundervalued) securities.

The efficient market hypothesis is generally accepted as being reasonable for securitiestraded on major exchanges; this is supported by research on the subject. There is anincreasing challenge to the efficient market hypothesis being offered by the study ofbehavior finance. The challenge comes primarily from the fact that tests of the efficientmarket hypothesis assumes that investors are completely rational. A going body ofresearch disputes this rationality assumption and shows that investors are driven by the

irrational behaviors of greed, fear, and other emotions.c) A financial manager must understand the valuation process in order to judge the value of

benefits received from stocks, bonds, and other assets in view of their risk, return, andcombined impact on share value.

Three key inputs to the valuation process are:

(1) Cash flowsthe cash generated from ownership of the asset;

(2) Timingthe time period(s) in which cash flows are received; and


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(3) Required returnthe interest rate used to discount the future cash flows to a presentvalue. The selection of the required return allows the level of risk to be adjusted; thehigher the risk, the higher the required return (discount rate).

The valuation process applies to assets that provide an intermittent cash flow or even asingle cash flow over any time period. The value of any asset is the present value of future

cash flows expected from the asset over the relevant time period. The three key inputs inthe valuation process are cash flows, the required rate of return, and the timing of cashflows.

d) Profit maximization is not consistent with wealth maximization due to: (1) the timing ofearnings per share, (2) earnings which do not represent cash flows available tostockholders, and (3) a failure to consider risk. Risk is the chance that actual outcomesmay differ from expected outcomes. Financial managers must consider both risk and returnbecause of their inverse effect on the share price of the firm. Increased risk may decreasethe share price, while increased return may increase the share price.

The goal of the firm, and therefore all managers, is to maximize shareholder wealth. Thisgoal is measured by share price; an increasing price per share of common stock relative tothe stock market as a whole indicates achievement of this goal.

bmmf5103 - answer scheme exam july 2012

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