MARKING SCHEME BMMF5103/JULY2012/F-AA

JULY 2012
MARKING SCHEME BMMF5103 - MANAGERIAL FINANCE
Suggested Answers:
PART A
Question 1
a)

The standard deviation of a distribution of asset returns is an absolute measure of

dispersion of risk about the mean or expected value. A higher standard deviation indicates
a greater project risk. With a larger standard deviation, the distribution is more dispersed
and the outcomes have a higher variability, resulting in higher risk. The coefficient of
variation is another indicator of asset risk, measuring relative dispersion. It is calculated by
dividing the standard deviation by the expected value. The coefficient of variation may be a
better basis than the standard deviation for comparing risk of assets with differing expected
returns.

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 same
direction are positively correlated, while those moving in opposite directions are negatively
correlated. Assets with high positive correlation increase the variability of portfolio returns;
assets with high negative correlation reduce the variability of portfolio returns. When
negatively correlated assets are brought together through diversification, the variability of
the expected return from the resulting combination can be less than the variability or risk of
the individual assets. When one asset has high returns, the others returns are low and vice
versa. Therefore, the result of diversification is to reduce risk by providing a pattern of
stable returns. Diversification of risk in the asset selection process allows the investor to
reduce overall risk by combining negatively correlated assets so that the risk of the portfolio
is less than the risk of the individual assets in it. Even if assets are not negatively
correlated, 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 the
amount of systematic risk associated with an asset and the required return. Systematic risk
is measured by beta and is on the horizontal axis while the required return is on the vertical
axis.

(i)

inflation: If there is an increase in inflationary expectations, the security market line will
show 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.
risk tolerance: The slope of the SML (the beta coefficient) will be less steep if investors
become less risk-averse, and a lower level of return will be required for each level of
risk.

(ii)

MARKING SCHEME BMMF5103/JULY2012/F-AA

d)

(i) E(r) = (0.5)(10%) + (0.25)(8%) + (0.25)(16%) = 11.0%

(ii) Beta = (0.333)(1.2) + (0.333)(1.6) + (0.333)(2.0) = 1.6
(a) The portfolio has more risk than the market.

e)

E(r) = (0.2)(30%) + (0.7)(15%) + (0.1)(-5%) = 16.0%

Therefore, market risk premium = (16.0% - 5.0%) = 11.0%.

Question 2
a)

(i) Accept project A and reject B since the payback period for the former is shorter (i.e. 2
years) than the latter (2.125 years).
(ii) Reject project A and accept B as the IRR for the former is lower (i.e. 23.38%) than the
latter (30.60%).

b)

Accept only X since its NPV is positive (i.e. RM3,803.88 ) than that of Z (i.e. -5,800.87)

c)

Net present value is considered a sophisticated capital budgeting technique since it gives
explicit consideration to the time value of money. If net present value of a project is greater
than zero, the firm will earn a return greater than its cost of capital. Such a project should
enhance the wealth of the firms owners. An internal rate of return greater than the cost of
capital guarantees that the firm earns at least its required return. Such an outcome should
enhance the market value of the firm and therefore the wealth of its owners. The IRR is the
discount rate that equates the NPV of an investment opportunity with $0. Because NPV
implicitly assumes that any intermediate cash inflows generated by an investment are
reinvested at the firms cost of capital, NPV is considered to be a better approach to capital
budgeting than IRR.

d)

Capital budgeting projects should be evaluated using incremental after-tax cash flows,
since after-tax cash flows are what is available to the firm. When evaluating a project,
concern is placed only on added cash flows expected to result from its implementation.
Expansion decisions can be treated as replacement decisions in which all cash flows from
the old assets are zero. Both expansion and replacement decisions involve purchasing new
assets. Replacement decisions are more complex because incremental cash flows deriving
from the replacement must be determined.

e)

Sunk costs are costs that have already been incurred and thus the money has already
been spent. Opportunity costs are cash flows that could be realized from the next best
alternative use of an owned asset. Sunk costs are not relevant to the investment decision
because they are not incremental. These costs will not change no matter what the final
accept/reject decision. Opportunity costs are a relevant cost. These cash flows could be
realized if the decision is made not to change the current asset structure but to utilize the
owned asset for its alternative purpose.

MARKING SCHEME BMMF5103/JULY2012/F-AA

PART B
Question 1
a)

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

b)

The nominal annual rate is 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 by
the borrower to the lender. The difference between the two rates is due to the compounding
of interest at a frequency greater than once per year. The effective annual rate increases
with increasing compounding frequency. The nominal and effective rates are equivalent for
annual 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 preferred
as the interest is being compounded only once a year as opposed to the frequent
compounding in the effective rate.

c)

Bank A: n 4, i 9%, m 1
FV 5,000(1.412) $7,060
Bank B: n 4, i 8%, m 2
FV 5,000(1.369) $6,845
Jamilah should deposit her money in Bank A and she will have $7,060 upon her
graduation from college.

d)

PMT

3,500,000/2.487

Year
0
1
2
3

$1,407,318.05

Payment
Principal
Interest
0
$3,500,000.00
$1,407,318.05 $1,057,318.05 $
350,000.00
1,407,318.05
1,163,049.85
244,268.20
1,407,318.05
1,279,354.84
127,963.21

Balance
2,442,681.95
1,279,632.10

MARKING SCHEME BMMF5103/JULY2012/F-AA

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 only
upon the expectation of future returns. They are not guaranteed any return, but merely get
what 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 are
placed in a quite uncertain or risky position with respect to returns on invested capital. As a
result of this risky position, they expect to be compensated in terms of both dividends and
capital gains of sufficient quantity to justify the risk they take.

b)

Rights offerings protect against dilution of ownership by allowing existing stockholders to

purchase additional shares of any new stock issues. Without this protection current
shareholders may have their voting power reduced. Rights are financial instruments issued
to current stockholders that permit these stockholders to purchase additional shares at a
price 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 FVIF
1.105 5%
$2.45
Po =
= $15.31
0.21 0.05
d)
t
1
2
3
4

Do
$2.00
2.00
2.00
2.00

FVIF5%,t
1.050
1.102
1.158
1.216

Dt
$2.10
2.20
2.32
2.43

PVIF8%,t
0.926
0.857
0.794
0.735

PV
$1.94
1.89
1.84
1.79
P1 $7.46

MARKING SCHEME BMMF5103/JULY2012/F-AA

D5

2.43 (1 0.03)

P2 =

2.50
1

= $36.75
0.08 0.03 (1 + 0.08) ^ 4

Value of stock
e)

$2.50

$36.75 $7.46

$44.21

Equity capital is permanent capital representing ownership, while debt capital represents
a loan that must be repaid at some future date. The holders of equity capital receive a
claim on the income and assets of the firm that is secondary to the claims of the firms
creditors. Suppliers of debt must receive all interest owed prior to any distribution to
equity holders, and in liquidation all unpaid debts must be satisfied prior to any
distribution to the firms owners. Equity capital is perpetual while debt has a specified
maturity date. Both income from debt (interest) and income from equity (dividends) are
taxed as ordinary income. To the corporation, debt interest is a tax deductible expense
while dividends are not.

Question 3
a)

The current ratio proves to be the better liquidity measure when all of the firms current
assets are reasonably liquid. The quick ratio would prove to be the superior measure if the
inventory 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 indicates
the rate of return they earn on their investment in the firm. ROE is calculated by taking
earnings available to common shareholder and dividing by stockholders equity.

c)
Sales
-COGS
GP
-opex
EBIT
-int
EBT
-tax(40%)
NI
-pfd divd
NI Cmn
# of Cmn
EPS

3060
1800
1260
600
660
126
534
213.6
320.4
18
302.4
1000
0.30

MARKING SCHEME BMMF5103/JULY2012/F-AA

d)

Sales

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

Total Assets Sales/(Total Asset Turnover)
150,000/0.50

Net Profits After Taxes

$300,000

(ROA) (Total Assets)

(0.02) (300,000)

e)

$6,000

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 sells
at a premium when 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 fixed
rate of interest, whereas the required return fluctuates with shifts in the cost of long-term
funds due to economic conditions and/or risk of the issuing firm. The disparity between the
required 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 coupon
interest rate, the bonds value approaches its $1,000 par value as the time to maturity
declines.

b)

Liquidity problems exist in thinly traded bonds, default risk is the likelihood the corporation
will default on its bond obligations, and the maturity premium reflects the fact that longerterm 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 yield
premium 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%

MARKING SCHEME BMMF5103/JULY2012/F-AA

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

Question 5
a)

The equation for the Capital Asset Pricing Model is:

kj

RF [bj (km RF)],

where:
kj
RF
bj
km

the required (or expected) return on asset j.

the rate of return required on a risk-free security (a U.S. Treasury bill)
the beta coefficient or index of nondiversifiable (relevant) risk for asset j
the 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 was
developed to explain the behavior of securities prices in efficient markets and uses
historical 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 has
not been found to be generally applicable to real corporate assets. However, the CAPM
can be used as a conceptual framework to evaluate the relationship between risk and
return.
b)

The efficient market hypothesis says that in an efficient market, investors would buy an
asset if the expected return exceeds the current return, thereby increasing its price (market
value) 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- or
undervalued) securities.
The efficient market hypothesis is generally accepted as being reasonable for securities
traded on major exchanges; this is supported by research on the subject. There is an
increasing challenge to the efficient market hypothesis being offered by the study of
behavior finance. The challenge comes primarily from the fact that tests of the efficient
market hypothesis assumes that investors are completely rational. A going body of
research 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, and
combined 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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MARKING SCHEME BMMF5103/JULY2012/F-AA

(3) Required returnthe interest rate used to discount the future cash flows to a present
value. The selection of the required return allows the level of risk to be adjusted; the
higher the risk, the higher the required return (discount rate).
The valuation process applies to assets that provide an intermittent cash flow or even a
single 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 in
the valuation process are cash flows, the required rate of return, and the timing of cash
flows.
d)

Profit maximization is not consistent with wealth maximization due to: (1) the timing of
earnings per share, (2) earnings which do not represent cash flows available to
stockholders, and (3) a failure to consider risk. Risk is the chance that actual outcomes
may differ from expected outcomes. Financial managers must consider both risk and return
because of their inverse effect on the share price of the firm. Increased risk may decrease
the share price, while increased return may increase the share price.
The goal of the firm, and therefore all managers, is to maximize shareholder wealth. This
goal is measured by share price; an increasing price per share of common stock relative to
the stock market as a whole indicates achievement of this goal.