MID TERM TEST

ADVANCED FINANCIAL MANAGEMENT (P4)

13 August 2009

Question 1
The managers of a pension fund follow an active portfolio management strategy. They
try to purchase shares and bonds that show a positive abnormal return (positive alpha
factor in case of shares). The pension fund is required by law to hold at least 40% of its
investments in bonds $100 million is currently available for investment.
Three shares and three bonds are being considered for purchase.
The required return on bonds may be measured using a model similar to capital asset
pricing model, where beta is replaced by the relative duration of the individual bond (D 1)
and the bond market portfolio (Dm). This is shown as D1/Dm.
Shares
Expected
return Standard deviation of Correlation coefficient of
(%)
returns
returns with the market
Equity market
10.5
15
1
Fitter plc
11.0
25
0.76
Star plc
9.5
18
0.54
Dust plc
13.5
35
0.63

Bonds
Bond markets
UK Government
Super plc
Tape plc

Duration (years)
7.5
1.5
8.6
14.2

Coupon (%)
8
6
9

Redemption yield (%)

5.8
4.5
5.3
7.2

The risk free rate is 4%.

Required
(a) Evaluate whether or not any of the shares or bonds are expected to offer a
positive abnormal return (alpha value).
(7 marks)
(b) The pension fund currently has the maximum permitted investment in shares
and wishes to continue this strategy. It has a market value of $1,000 million and
beta of 0.62.
Calculate the required return from the pension fund if any shares and bonds with
positive abnormal returns are purchased.
State clearly any assumptions that you make.
(3 marks)

(Total 10 marks)
Question 2
The selection of appropriate discount rates for capital investments had frequently been a
problem for the finance director of Tovell Inc. the company has adopted a strategy of
diversification into many different industries, in order to reduce risk for the companys
shareholders. This has resulted in frequent changes in the companys gearing level and
widely fluctuating risks of individual investments.
The current project under appraisal, an investment in the fast food industry where Trovell
has no other investments, is expected to generate pre-tax operating cash flows of
$420,000 in the first year, rising by 5% per year for the five-year expected life of the
project. After the five years the land and buildings are expected to have a realizable
value of $1,250,000 (after any tax effects), the same as their original cost, but in order to
continue operations major new investment in equipment would be required at that time.
Other non-current assets would have negligible value after five years. The total initial
outlay of the project (net of issue costs) is $2.3.million, and all but the land and buildings
attracts a 25% per year capital allowances on a reducing balance basis.
The project would be financed by an $800,000 fixed-rate loan from a regional
development agency at a subsidized interest rate of 6% per year, 3% less than Tovell
could borrow at in the capital market. The remainder of the finance would be provided by
an underwriting and issue costs of 5% of gross proceeds. The investment is believed to
add $1 million to the companys debt capacity.
Current financial data for Trovell and the fast food industry includes:

P/E ratio
Dividend yield
Equity beta
Debt beta
Gearing (debt/equity):
Book values
Market values
Share price
Number of ordinary shares

Trovell Inc
12
5%
1.1
0.2

Fast food (industry)

20
3%
1.4
0.23

1.1:1
0.4;1
470 cents
3.5 million

1.6:1
1 to 1
n/a
n/a

The corporate tax rate is currently 30% per year, and tax is payable one year in
arrears.
The Treasury bills are currently yielding 5% per year after tax, and the return
required by well diversified investors is 12.5% per year.
Required

(a) Provide a reasoned explanation as to whether you would support the

companys strategy of diversifying into many different industries.
(8 marks)
(b)

Prepare a report for the finance director of Trovell Inc. advising on the
financial viability of the proposed fast food investment. Include in the report
an assessment of the limitations of the method of appraisal that you have
used. Supporting calculations should form an appendix to your report.
(22 marks)
(Total 30 marks)

Question 3
You have been appointed as the chief financial officer of a multimedia company
which is financed by private equity. There is considerable public interest in the company
and it continues a very rapid rate of growth under the leadership of its dynamic founder
and chief executive officer, Encik Abu Bakar. He owns over 30 per cent of the companys
equity and has also loaned the business sums to sustain its overseas development. The
balance of the other investors consist of some small shareholdings held by current and
past employees and the remainder is in the hands of a private equity company which is
represented by two directors on the board.
You enjoy a substantial salary and package of other benefits. Your role description
gives you overall responsibility to the board for the financial direction of the company, the
management of its financial resources, direction and oversight of its internal control
systems and responsibility for its risk management. After two months in the job you are
called to a meeting with Encik Abu Bakar and the companys non-executive chairman. In
that time you have made significant progress in improving the financial controls of the
business and current year end, which is three weeks away, looks very promising. the
companys underlying earnings growth promises to be in excess of 20 per cent and its
cash generation is strong. The CEO tells you that he would like you to put together a
plan to take the company to full listing as a first step to him undertaking a substantial
reduction in his financial stake in the business. he tells you that this discussion must be
confidential, as he expects that the market would react adversely to the news. However,
he would like to see what could be done to make sure that the year end figures are as
strong as possible. given your performance, he also tells you that they like to offer you a
substantial incentive in the form of share option.
Required
Discuss any ethical considerations or concerns you may have concerning this proposed
course of action.