Instructions and Questions for Business Valuation and Risk Management Exam

Answer Five questions.

All questions carry equal marks.

1. Candidates must complete the front cover sheet and include it in the final documents submitted.

2. Candidates must NOT communicate electronically or verbally with anyone about the content of the examination during completion of the examination.

3. Candidates must complete the answers in MS Word

4. Please begin each question on a new page.

5. Questions answered must be noted on the left hand side of each page.

6. Each page must include a page number.

7. FAILURE to do so will result in a zero mark.

8. Candidates must submit their completed exam script (word document) via email to the following email address: [email protected]

9. Only ONE email submission and ONE attachment (either Word ) will be permitted.

The income statement of David B2L plc for the year ended 30th April 2020 is summarised below:

Following a detailed strategic analysis, the following estimates have been made:

a. A programme of modernisation and replacement of equipment is expected to result in a strategical drift from the firm’s strategic position which would generate unfavourable cost consequences that would negatively impact the ratio of operating cost to sales by two percentage point from the previous year’s level. This adverse cost impact would be felt in the first year (i.e. 2019-20), and the operating cost ratio would remain at that level thereafter.

b. David B2L plc’s management would be able to increase the turnover at the rate of 5% in real terms for the next three years, after which the turnover is expected to remain stable in real terms.

c. Inflation is currently 2.5% per annum, and the average inflation rate is expected to continue at this level for the foreseeable future.

d. The corporation tax rate is 19% - The company has no debt.

e. The company’s beta is 1.5, the rate of return on Treasury Bills is 1.6% and the expected rate of market risk premium is approximately 7.2%.

f. The capital expenditure required to complete the modernisation and replacement programme would be spread over the first three years, and would amount to 25% of the incremental sales in each of those years.

g. Other routine capital expenditure would be roughly equal to the annual depreciation charge.

10. The average level of working capital maintained by David B2L plc’s during any one year is equal to approximately 20% of the sales for that year; working capital would need to be maintained at the level required to sustain the anticipated increase in turnover.

Instructions to Candidates

a) Perform a DCF valuation of David B2L plc’s, using shareholder value analysis and the information provided above. (15 Marks)

b) Distinguish between entity valuation and equity valuation, and comment upon the relevance of the distinction in the case of David B2L plc’s. (5 Marks)

Colombo City Computers LTD, a computer manufacturing company based in Sri Lanka, has received an order for export of 1000 computers from Prajakta UK Ltd, invoiced at GBP 1,500 each. These computers are to be shipped from Sri Lanka immediately, but receipts in GBP is only expected in 3 months' time. Colombo City Computers LTD operates a bank overdraft account that is fully drawn, and the company has no spare cash to finance the credit period.

Colombo City Computers LTD does not have an established risk management policy. The Finance Manager is undecided about whether the currency risk of the transaction should be covered through the forward market, or by using futures or options.

The company can borrow and deposit short-term funds in the London and Indian markets at the following rates:

Colombo City Computers LTD faces a potential $100 million loss that it would like to insure. Because of tax benefits and the avoidance of financial distress and issuance costs, each $1 received in the event of a loss is worth $1.50 to the firm.

Two policies are available: One pays $55 million and the other pays $100 million if a loss occurs. The insurance company charges 20% more than the actuarially fair premium to cover the administrative expenses. To account for adverse selection, the insurance company estimates a 5% probability of loss for the $55 million policy and a 6% probability of loss $100 million policy.

a) Advise Colombo City Computers LTD whether the forward market or the money market would offer the cheaper hedge; your recommendations should be supported by appropriate calculations. Ignore transaction costs. (Exhibit -1). (8 marks)

b) Explain the main advantage and main disadvantage of using an option contract rather than a forward or futures contract as a hedge against currency risk. (6 marks)

c) Suppose the beta of the risk is zero and the risk-free- rate is 5%. (Exhibit -2) Which insurance policy would the firm choose if its risk of loss is 5%? (6 Marks)

The value of Rambha & Urvashi plc is currently £100 million. The company proposes to invest in a project which will increase the value of the business to £125 million. The new project has an expected internal rate of return of 10%, and a standard deviation of return of 6%. Rambha & Urvashi plc’s existing activities have an internal rate of return of 16% and a standard deviation of return of 9.5%. The coefficient of correlation between the return on Rambha & Urvashi plc ’s existing activity and the expected return on the new project is 0.43

Rambha & Urvashi plc’s investment sector based analysis- summary report given below

Three of the Rambha & Urvashi plc’s equity fund managers have achieved the following performance- (risk free rate of 2.60%)

Note: For answering parts (b) and (c) of this question use the formula for portfolio standard deviation: