Question 1: Capital Expenditure Decisions and Investment Criteria - Morten Ltd
In recent years Morten Ltd, a company that manufactures and markets a range of pharmaceutical products, has been highly profitable. Its success has been based to a large extent on its ability to generate and market new and innovative products on a regular basis. The latest of these products has just completed various tests to ensure it meets regulatory requirements and a decision now has to be taken on whether or not to proceed with an investment in the facilities required for manufacturing the product. You are required to undertake an evaluation of this potential investment.
The company has already spent £800,000 on the research programme from which this product has emerged. A number of other products are expected to get to the testing stage within the next few months. While is impossible to allocate accurately the expenditure incurred to the different products generated by the research programme it is agreed that the development of the product under consideration accounts for at least 40 per cent of the programme's expenditure of £800,000.
The company will have to cover the cost of further testing of the product to be undertaken by the regulatory body and this is expected to be about £90,000. The development director is very confident that the tests will be successful as they have already been rigorously undertaken by the company and no problems were identified.
The company anticipates that the product will remain competitive for the next five years after which it is likely to be displaced by the new products that are always being developed as the underlying technology evolves. In the first year it is anticipated that 200,000 units will be sold at a price of £12. From year two through to year four sales are expected to be 300,000 units per annum but are expected to fall back to 200,000 units in year five. It is anticipated that the price of the product will remain unchanged over the five year period.
The product will be manufactured in a factory already owned by the company that has considerable spare capacity. It is very unlikely that the space taken up by the manufacture of the product will be required for any other purpose over the five year period that is planned for its manufacture. In the company's management accounting system all products are charged for the factory space that they require and this will amount to £30,000 per annum.
The machinery required for the manufacture of the product will cost £1,200,000. It will have to be depreciated for tax purposes on the basis of an annual 25 per cent writing down allowance (ie. 25 per cent of the remaining book value of the asset having allowed for the allowances claimed in previous years). At the end of the five year period the machinery will be sold or, if it is more profitable, used in the manufacture of other products. The resale value of machinery of this nature after being used for five years is likely to be about 30 per cent of its purchase price.
The cost of the labour and materials required for the manufacture of the product has been estimated at £7.50 per unit, with materials accounting for 40 per cent of the cost and labour the residual 60 per cent. There are also fixed costs of £150,000 per annum stemming from the manufacturing process. The product will also be charged an allowance for general overheads by the management accountants, set at 5 per cent of the revenues produced by the product. The overheads include the company's expenditure on new product development - an important expense of the company. The initial marketing of the product will cost £250,000 and the sales support per annum will cost £100,000. It is anticipated that the company will have to invest in working capital - holding finished products equivalent to 20 per cent of next year's sales, 25 per cent of the materials required for the next year, and it is expected that debtors and creditors will just about offset each other. The tax rate is 40 per cent and the required rate of return on investments of this nature is 16 per cent.
a) Determine the investment’s net present value, the internal rate of return and payback period. All key assumptions should be specified and explained.
b) Interpret the reported NPV, IRR, payback and the discount payback period, using the proposed investment to illustrate your answer.
c) Analyse the inputs into the analysis to which the NPV most sensitive.
Question 2: Valuation of a Company's Shares
Identify the (current) price earnings ratios for three companies traded on the London Stock Exchange and indicate how the ratio has changed over the last five years. Discuss the factors that might explain the differences between the price earnings ratios for the three companies and the changes that have occurred in their price earnings ratios over the five year period. (Choose companies with a range of P/E ratios to give you one with a relatively low value, one with a relatively high value, and another with a middling value.
You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.
Question 3 : - Barclays Bank announced its intention to undertake a rights issue to raise £5.8 billion on the 29th of July this year (2013).
a) Provide comments on the financial position and performance of the Bank and the rationale provided for the issue .
b) Specify the terms of the issue, the anticipated ex-rights price and calculate the value of a right.
c) Demonstrate that an investor at the time of the issue will in principle be equally well off from investing in the issue or selling the rights they have been allocated.
d) Comment on the market’s reaction to the announcement of the issue. Use financial theory to try to explain the reaction
Question 4 : - The attached file (Portfolio Analysis 2012-13) gives 60 monthly returns for thirty securities drawn from the FT ALL Share Index for the period January 2001 and December 2005. (These months were chosen to avoid the period of the financial and economic crises from 2007 onwards.)
a)
i. Choose any five securities at random and determine (using Excel functions) the average monthly returns for each company for the 60 months along with the variance and standard deviation of these returns. Next construct an equally weighted portfolio made up of the five securities, and determine the series of monthly returns. On this basis determine the average return for the portfolio and the associated variance and standard deviation.
The averages, variances, and standard deviations can be derived using the relevant Excel functions. Utilise the Excel specification for population variance and standard deviation – STDEVP and VARP – in the calculations.
Explain the discuss the relationship between the average returns, average variance, and average standard deviation for the five securities and the average returns, variance, and standard deviation for the portfolio.
ii. Determine the co-variances for each pair of securities in the portfolio and on the basis of this information along with the variances for the returns for the securities calculate the average variance and average co-variance. Using the portfolio equation for an equally weighted portfolio, calculate the standard deviation of the returns on the portfolio. Compare your results to those obtained for the portfolio in part i above. Comment andexplain your findings.
b) Choosing securities at random to form equally weighted portfolios of 1, 5, 10, 15 and 20 securities and determine the standard deviation of these portfolios. Next plot your results for the standard deviations against the number of securities in the portfolios. Comment on your results and compare these with the results of the studies of naïve diversification. (In undertaking this analysis you can derive the results for each of the portfolios using the Excel spread-sheet – there is no need to employ the portfolio equations and estimates of co-variances etc.)
(Approximately 500 words)
c) Determine the beta of one security by regressing the returns for the share on the returns for the FT ALL Share Index (the last column in the spread-sheet). Comment on what the value of the beta (the slope coefficients in the regression) indicates and discuss the primary determinants of a share’s beta